As new Federal Reserve Chair Jerome Powell takes office this week, the U.S. economy is stronger than it has been in many years. Unemployment remains low and stable, economic growth continues to accelerate, signs of robust wage gains have finally appeared, and inflation, though puzzlingly slow, is still expected to return to the Fed’s two percent target over the intermediate term. Additional monetary tightening will be required against this most favorable backdrop. But, very much to her credit, former Chair Janet Yellen has already prepared the public for further rate hikes. No one will be surprised if, at his first press conference on March 21, Chair Powell announces another quarter-point increase in the Fed’s key policy rates.
These encouraging signs of economic strength and stability also give the new Fed chair an opportunity to enhance monetary policy in ways of his own design. With the first of its congressionally-mandated goals – maximum sustainable employment – already achieved under Yellen’s leadership, it now makes sense for Powell to focus on the remaining objective: price stability. As noted above, inflation continues to run stubbornly below the Fed’s two percent target. Naturally, this has raised questions about how seriously the Fed takes that target and whether important adjustments may be needed to make the target more credible. Chair Powell could help resolve this tension and uncertainty by reaffirming the Fed’s commitment to two percent inflation as a long-run target, while also placing an explicit band around two percent to indicate more clearly the extent to which he is prepared to accept short-run deviations from that long-run goal.
Although more research is needed to determine the exact width of an optimal short-run inflation band, a sensible first guess might place lower and upper bounds at 1.5 and 2.5 percent, making for a symmetric range of one percentage point centered around the long-run target. Thus, the graph below superimposes this band on a plot of actual inflation, measured by year-over-year changes in the price index for personal consumption expenditures excluding food and energy, extending back to the mid-1990s.
When presented in this way, the data point to two conclusions. First, even though the Federal Reserve did not officially announce its long-run target until 2012, it appears to have been very successful at stabilizing inflation in the two percent range for more than two decades. But second, over the same extended period, inflation has always exhibited sizeable short-term fluctuations and, even before the financial crisis and Great Recession of 2007-09, did at times fall below 1.5 percent without disastrous consequences.
With reference to such a graph, Chair Powell could reassure skeptical observers that the Fed can deliver two percent inflation, on average, over long periods of time. But he could also remind them that it is unrealistic for anyone to expect actual inflation to be constant or nearly so, even over periods lasting several years. The Fed simply lacks the power to fine-tune the economy with that degree of precision.
Making consistent reference to a short-run band around the long-run target would also help Chair Powell and his colleagues on the Federal Open Market Committee resist their own temptation to try too much fine-tuning. If, whenever inflation falls below the two percent target, the FOMC responds with overly-aggressive policy easing, it will then be forced to tighten with too much vigor later on, as inflation overshoots. The result would be a return to the “stop-go” policy pattern that led to alternating bouts of inflation and recession throughout the 1970s. The most important feature of a successful inflation-targeting regime is that it keeps policymakers focused on maintaining stable prices in the long run and thereby contributes to better economic performance in the short run as well.
Critics of the Fed are rightly concerned that, as shown in the graph, inflation has run persistently below the two percent target for more than a decade now. But Chair Powell can explain to those critics that, indeed, precisely because inflation continues to skirt the lower bound of its acceptable range, the Fed is holding policy rates well below levels that would ordinarily prevail at this stage of an economic expansion. Chair Powell could also point to a symmetric band around two percent as evidence that, consistent with their previous statement of longer-run goals and strategy, FOMC members take shortfalls of inflation below target as seriously as they do overshoots above.
Thus, by using a short-run target range to clarify what the Fed can and cannot do, new Chair Powell would solidify his reputation both as a skillful consensus-builder and a staunch defender of the Fed’s commitment to long-run price stability. He would highlight the impressive record that past Fed chairs have had in stabilizing inflation, while enhancing a strategy to achieve similar success of his own.
Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.
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