In late August, Fed Chairman Jerome Powell suggested that the Federal Reserve would begin tapering before the end of the year admit an admission that price inflation was rising above the two-percent target. Nonetheless, the Fed took no immediate action in the following month. This week, Powell again suggested a taper would begin soon, stating it would begin soon enough that the process could “conclud[e] around the middle of next year,” and maybe could begin in November. This, of course, was highly conditional, with Powell noting this taper would only happen if “the economic recovery remains on track.”
Some interpreted this as a hawkish turn for Powell, but again, we should expect no immediate action on this. Lackluster economic growth remains a concern and Powell’s qualifier on the “recovery” remaining on track will be key. Last week, Goldman downgraded the US economic growth forecast, and the Beige Book—which always casts economic growth in a rosy glow—also reduced its description of the economy during July and August to ”moderate.” Meanwhile, the Bank of England today signaled a worsening global situation with its own downgrade of growth expectations. In other words, if the economy isn’t improving enough—according to the Fed—then it can simply abandon plans to taper.
In other words, we may be looking at a repeat of the decade following the Great Recession. Growth was remarkably slow in those days in spite of immense amounts of monetary stimulus. The Fed repeatedly spoke of an “improving economy,” however, and repeatedly hinted as tapering. It was only in 2016 when the Fed dared to allow the target interest rate to inch upward. This was done out of fears the Fed would have no room to maneuver in case of another crisis.
But in 2017 and 2018, when CPI inflation began to push above two percent, the expectation arose that the Fed would finally begin to meaningfully taper to keep target inflation near the state two-percent target. This alarmed some inflation doves who were concerned—with good reason—that any reining in of the Fed’s easy-money policies would end the very fragile and lackluster recovery then underway. The repo crisis of 2019 was the first sign of trouble in the Fed’s very-minor tapering effort. But, any other brewing liquidity crises were soon obscured by the covid crisis and the economic collapse that followed.
The target interest rate was quickly returned to 0.25 percent, and additional asset purchases resumed at breakneck speed, with the Fed’s portfolio soon topping eight trillion dollars.
But doves nonetheless felt the Fed had been too aggressive against price inflation, and the covid crisis gave doves an opportunity to press their case. In August of 2020, the Fed adopted a new policy in which it would pursue an “average” two-percent inflation goal. In other words, the Fed could now pursue a price-inflation goal above two percent so long as it all averaged out to two percent over time.
But even that hasn’t been enough for the advocates of ever more price inflation.
The Fed now admits that inflation has again surged above the official inflation target, with expectations of an inflation rate exceeding four percent at year’s end. (This is CPI inflation, of course, not the much-larger asset-price inflation which the Fed studiously ignores.)
The longer inflation persists above the target rate, the more the Fed will feel pressure to bring inflation back down through some sort of tapering. This is the last thing the doves want, and many suspect today’s weak economy can’t handle even a little bit of tapering.
The new “two-percent average” standard adopted last year helped buy the doves some time, but we’re now beginning to see calls for scrapping the two-percent standard altogether.
Writing at the Wall Street Journal earlier this month, Greg Ip noted that Powell appears to be banking on the inflation rate soon returning to two percent. But what if it doesn’t? Ip says if inflation remains above targets, the Fed should just raise the targets. He writes:
One strategy [Powell]—or his successor—should consider in that eventuality is to simply raise the target.
And why pursue higher inflation? Ip takes the popular view of the “mythical trade-off between higher employment and inflation”—as Brendan Brown describes it. For Ip, higher inflation means an employment-fueled expansion, and he writes:
Why would higher inflation ever be a good thing? Economic theory says modestly higher, stable inflation should mean fewer and less severe recessions, and less need for exotic tools such as central-bank bond buying, which may inflate asset bubbles. More practically, if inflation ends up closer to 3% than 2% next year, raising the target would relieve the Fed of jacking up interest rates to get inflation down, destroying jobs in the process.
In other words, Ip has had enough of central bank policy being tied explicitly to the two-percent standard. According to Ip, the too-low two-percent target places the Fed in a straight jacket. Rather than feel the pressure to taper just because price inflation has risen above the two-percent target, Ip wants to make sure the Fed can just keep on with the stimulus until price inflation exceeds three percent, or maybe even four percent. And who knows? After that, maybe “economic theory” will tell us that five percent inflation is an even better target. Certainly, that would be no less arbitrary a number than four percent or two percent.
But it’s a safe bet that if the accepted inflation target were four percent, we’d be hearing little-to-nothing right now about tapering, normalization, or any other effort to cut price inflation. The Fed would then be more free to keep the easy-money spigot open longer without having to hear complaints that the Fed had “lost control” of price inflation. That would be great for stock prices and real estate prices. Ordinary people, on the other hand, might fare less well.
