Price stability and the Federal Reserve

The Price Stability Act of 2022, a bill before the House Financial Services Committee, would turn the Federal Reserve’s dual mandate into a single mandate. Instead of maximum employment and stable rates, the Fed will seek only stable rates. Is this a welcome change? Without ratification or condemnation of the bill, we can explore its costs and benefits.

The law did not define the meaning of “price stability”. For now, we can interpret it as an inflation target. Whether the actual number is 2 percent or 0 percent doesn’t make much difference. As long as the price hike is minimal and predictable, many different target numbers can succeed.

While the Fed currently has a “medium” inflation target of 2 percent, it has chosen itself, and therefore cannot commit. The Federal Reserve is essentially a judge in its own case. They might say, “We investigated ourselves and decided we had done nothing wrong.” Congress’ imposition of the inflation target on the Federal Reserve may have teeth.

A binding outcome target is better than the unverifiable bogus target the Federal Reserve now has. According to the Fed’s own interpretation, the target is asymmetric: they are comfortable with inflation above 2 percent but not less than 2 percent. Markets are rightly skeptical about the Fed’s credibility, which affects its ability to implement monetary policy.

Establishing a predictable growth path for the value of the dollar has definite economic benefits. Most economists think of “future direction” (central banks communicate their intentions to future policy) in terms of interest rates. This is a mistake. Interest rates are prices for capital, and therefore time. Central banks should not mess with them. On the other hand, price-level forward steering is very useful. It creates a stable basis for economic activity by giving trade a measuring rod. No one can effectively prepare for a race if the definition of the meter is constantly changing. A similar fact applies to economic activity. The unpredictability of the price level can lead to underproduction in the short run or overproduction and underinvestment in the long run. In contrast, a credible commitment to the growth path of the purchasing power of the dollar creates a strong basis for markets to provide full employment today, and may have beneficial growth implications tomorrow.

But the inflation target has some drawbacks. Imagine we’re seeing a productivity slowdown on a large scale, making turning inputs into outputs somewhat more difficult than expected. This is an example of what economists call a negative supply shock. Prices will rise at the level of the economy, which means that the purchasing power of the dollar will decrease.

Supply problems create inflation. The inflation-targeting Fed will have to cut back on total spending (total demand) to bring down inflation again. But this means that real output and employment, already damaged by the supply shock, will take a second hit. The central bank will achieve the inflation target at the expense of exacerbating the economic downturn.

A Fed mandate that focuses on nominal spending growth rather than inflation may avoid this problem. Aggregate demand means nominal GDP: output estimated at current market prices. In the event of a supply shock, a Fed targeting spending growth would not need to reduce aggregate demand to bring down inflation. On the contrary, it will allow inflation to hamper some of the damage caused by slowing productivity. Production and employment will continue to decline. Difficulties on the supply side make this inevitable. But the Fed will not multiply the damage. In fact, the spending growth target appears very close to the first best policy. The increasing scarcity of commodities relative to money means that The price of money should go down. Inflation, in this case, reveals a glut of money compared to goods. It has no independent negative well-being consequences.

The spending growth target also tends to achieve price stability in the long run. Symptom shocks are usually temporary. When productivity issues are resolved and production is back on trend, so are prices. Hence, the expenditure growth target can also be justified by a mandate regarding price stability only.

The inflation target is not as good as the spending growth target. But this does not mean that the inflation target is undesirable. We rarely get our choice of the best policy. The second best we can hope for given the constraints of the political system. If the choice is between the inflation target and nothing, there are strong reasons to prefer the inflation target. We need to make the Fed subject to results-based rules. Discretion in monetary policy works poorly, and it is difficult to reconcile it with the rule of law besides.

Politics is a compromise. Half a loaf is better than no loaf at all. Price stability is half the loaf of monetary policy rules. It seems foolish to go hungry just because fine cuisine is unsustainable.

Alexander William Salter

Alexander W Salter

Alexander William Salter is the Georgie J. Snyder Associate Professor of Economics at Rawls School of Business and a Comparative Economics Research Fellow at the Free Market Institute, both at Texas Tech University. He is a co-author of Money and the rule of law: generality and predictability in monetary institutions, published by Cambridge University Press. In addition to his numerous scholarly articles, he has published nearly 300 opinion articles in leading national media outlets such as The Wall Street JournalAnd the National ReviewAnd the Fox News opinionAnd the hill.

Salter holds master’s and doctoral degrees. He holds a PhD in Economics from George Mason University, and a BA in Economics from Occidental University. He was a participant in the AIER Summer Fellowship Program in 2011.

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