Better Inflation Targets Will Help in the Next Recession

(Bloomberg Opinion) -- Almost 10 years after the Great Recession ended, the growing threat of a new economic slowdown raises a troubling question: When the next recession strikes, what can the world’s central banks do? With interest rates low and their balance sheets still loaded with assets bought to fight the 2008 crisis, do they have the tools to respond? This column is one of six looking at that question.

To its credit, the Federal Reserve is holding a conference this summer on whether it should make changes to how it operates. The first question on its agenda should be how to handle the next recession.

That’s not because it’s the organization’s only mission. A 1977 law directs it to seek “maximum employment, stable prices and moderate long-term interest rates.” But recent experience suggests that it’s the first part of that mission that is most in question over the course of the business cycle.

From roughly 1966 through 1981, many observers had justifiable doubts about whether the Fed could vanquish inflation. But since then, the Fed has been winning that battle in a rout. It has arguably been too successful: Over the last decade, it has consistently missed its inflation target by falling short of it rather than exceeding it.

The Fed did not perform as well during the financial crisis, the Great Recession and their aftermath. That proposition is controversial, since it is often claimed that the central bank’s stimulative policies, combined with the bipartisan Troubled Assets Relief Program and President Barack Obama’s fiscal stimulus, rescued us from a reprise of the Great Depression.

Fed policy was too tight during 2008. It held interest rates flat from April to October even as the economy was weakening, and spent much of that time signaling that higher interest rates were on the way. Officials were warning about the dangers of inflation while the market indicators showed that the expected rate was falling. 

Even when Lehman Brothers collapsed, the Fed cited inflationary risk and declined to reduce interest rates. Weeks later, it took the contractionary step of starting to pay interest on banks’ excess reserves. Only then did it reduce the federal-funds rate. Even Ben Bernanke, then the Fed’s chair, has said that it waited too long to cut interest rates.

After the crisis hit, the Fed kept the federal-funds rate low and engaged in several rounds of quantitative easing. Its policies were therefore commonly described as accommodative. But these policies were much less stimulative than apparent at first glance.

The neutral interest rate in a depressed economy is low, so actual interest rates have to be even lower to give the economy a lift. The Fed undercut the effect of its expansions of its balance sheet on market expectations of future income by signaling that those expansions would be temporary. And it continued to pay the banks interest on excess reserves.

In part because of the consensus that monetary policy was already quite easy, the Fed refrained from moving to an easier policy even as unemployment remained high and inflation persistently registered below the target of a 2 percent annual rate.

Had it wanted a more expansionary policy, the central bank could have stepped up its asset purchases or reduced the interest rate it paid on excess reserves. Instead, Fed officials spent much of the recovery debating when to “normalize” — in other words, raise — interest rates.

They eventually started to raise those rates in 2015, even as inflation stayed below the 2 percent target. While the Fed could certainly have pursued an even tighter monetary policy, as the European Central Bank did for much of this time, it could and should have done more to aid the post-crisis economy.

This record has raised several unpleasant questions about the next time the economy slumps: Are interest rates too low for the Fed to provide much support for the economy by reducing them? Will political constraints keep it from making enough asset purchases?

Another concern should be added to the list: Will the Fed repeat the mostly unacknowledged mistakes it made from 2008 onward?

The danger is that these questions will have the wrong answers if the Fed continues its current approach to monetary policy, which militates in favor of adjusting it in a few ways.

First, the policy of targeting 2 percent annual inflation should be modified. The Fed is already considering shifting to a 2 percent “average” target. If inflation misses the target in one period, the Fed would make up the difference in the next. That shift would have the virtue of making the long-term price level more predictable.

But there are different ways the Fed could hit this average, and their effects vary. Typically inflation is higher in a boom and lower in a bust; that is, it amplifies the business cycle. Central banks should strive for a counter-cyclical policy, with inflation moderating during a strong economy. Real growth and inflation should, that is, vary inversely.

If total dollar spending throughout the economy rises at a steady rate, that goal will be achieved automatically, since total dollar spending growth is simply the real economic growth rate plus the inflation rate. The Fed could adopt a dollar-spending target. It is consistent with an average inflation target so long as the economy has a roughly stable trend rate of growth. If the economy grows at 2 percent per year, on average, a 4 percent annual rise in spending will mean 2 percent inflation, on average.

But there is this difference. Hewing to an inflation target can mean changing monetary policy in response to a supply shock.

Higher oil prices, for example, can make an inflation-targeting central bank raise interest rates to keep the general level of prices from rising too far. That’s part of what happened in 2008, in fact. Responding that way to an adverse supply shock is pro-cyclical, since it compounds the damage from higher oil prices with a restrictive interest-rate policy. Conversely, an inflation-targeting central bank can respond to a burst of productivity, which tends to lower prices, by loosening money when the economy does not need it.

Under a dollar-spending target, the Fed would not change monetary policy in response to either positive or negative supply shocks. The central bank would have little need even to keep track of them. It would respond only to changes in the demand for money balances, raising the money supply when that demand increases and lowering it when it decreases so as to keep dollar spending on track.

This dollar-spending target (or modified inflation target) would be an improvement over current practice in several respects. It would generate counter-cyclical inflation and respond appropriately to both supply and demand shocks. It’s consistent with an inflation target — and, because it includes a commitment to make up for missing the target in one period, might do better in the long run at making the price level predictable than current practice.

Inflation targeting has worked, albeit imperfectly, in large part by anchoring expectations of inflation. The new monetary regime would also shape expectations — but here would be another advantage. To the extent the commitment to make up for spending shortfalls in one period with higher spending in the next period is credible, market expectations of future spending will be buoyed.

These expectations would put a floor under the neutral interest rate and make the Fed’s job that much easier. (Ditto for the commitment not to let spending drop in the case of an adverse supply shock.)

Using the new dollar-spending target would be even more effective if the Fed moved back to its pre-2008 policy of refraining from paying interest on reserves, since that policy put a floor under the nominal interest rate and thus makes it harder to stimulate a weak economy.

During the last century we have had two significant shifts in the framework for monetary policy. The interwar gold standard was abandoned by one country after another when it proved conducive, in some cases, to a ruinous decline in spending levels during the Great Depression. The later practice of using monetary expansion to boost the economy led, starting in the late 1960s, to high and unstable spending growth, and therefore to high and unstable inflation, and was abandoned in its turn.

Compared with the previous monetary regimes, inflation targeting has led to lower peaks for unemployment and for inflation. But by now we have enough experience of its flaws to see a way to make spending growth more stable and, particularly, to minimize both the likelihood and the severity of recessions.

Adopting the right policy framework is the key, which is to say that the time for the central bank to start fighting the next recession is before it begins.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Ramesh Ponnuru is a Bloomberg Opinion columnist. He is a senior editor at National Review, visiting fellow at the American Enterprise Institute and contributor to CBS News.

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