A Higher Inflation Target Won't Make the Fed More Effective
(Bloomberg Opinion) -- As promised by Federal Reserve Chair Jerome Powell, U.S. central bankers have embarked on a comprehensive review aimed at making monetary policy more effective. They will draw on both internal and external inputs and, according to a report over the weekend in the Wall Street Journal, consider “whether to allow inflation to rise above their 2 percent target more often as they grapple with the likelihood that interest rates are likely to remain much lower than in the past.” They could make this happen directly by changing the inflation target and/or adding both backward-looking and expectation components, or indirectly by opting for a price-level target.
This basic question pertains to inflation, one of the two components of the Fed’s dual mandate. It would be a lot easier to answer if the central bank’s policy making was taking place in (or near) a “first best” – that is, if it was fully supported by other parts of government with economic policy making capabilities. But this has not been the case for the last 10 years or so as political polarization on Capitol Hill has frustrated the deployment of a full set of policy responses that targets more dynamic productivity and higher inclusive growth. As such, central banks have had to carry an excessive policy burden. While the situation has gotten better for the Fed (though not for the European Central Bank, for example) with the adoption of some pro-growth policies in the last few years, it’s still living in a world of second best in terms of policy and the economy.
That reality is likely to continue for now, and the review of the inflation target raises two fundamental questions that assume even greater relevance in the context of today’s fluid world and remaining structural impediments to high and inclusive growth. Will the Fed be able to meet a higher inflation target if it already struggles to meet its current one on a consistent basis; and how does the balance of benefits-costs-risk evolve if the central bank pursues a higher inflation target?
Having endured the global financial crisis and overcome disruptions in the critical payments and settlement process, the Fed was forced in 2010 to rely on using the “asset channel” to deliver macroeconomic outcomes. By keeping interest rates at zero and injecting liquidity through large-scale asset-purchase programs (successive rounds of quantitative easing), the Fed was hoping to activate nominal gross domestic product using the wealth effect and animal spirits to help it meet its dual mandate of maximum employment and stable inflation.
What the Fed has learned (as detailed in my recent book “The Only Game in Town”) is that this kind of intervention is not sufficient, even if it’s deemed necessary. Moreover, the economic and financial linkages that work in the transmission mechanism seem to become less effective the longer the Fed relies on unconventional measures. Meanwhile, the risks to future financial stability rise, as does exposure to political interference, credibility and reputation challenges.
Simply put, there is a limit to how much the U.S. central bank can decouple asset prices from underlying economic and corporate fundamentals, let alone avoid the risk of encouraging liquidity mismatches and asset misallocations. The adoption of pro-growth measures in the form of deregulation and tax cuts has reduced some of the Fed’s policy burden but, as highlighted by last month’s dramatic policy pivot, has not eliminated the tricky codependence with markets.
The Fed has made significant progress on both its employment and inflation objectives, and it’s far from obvious that it needs to turbocharge its policy framework further if the goal is just to meet its current mandate. The economy is already close to or at full employment. At the same time, inflation is approaching the 2 percent target and measures of inflationary expectations, while inevitably noisy, have not shown a tendency to persistently trend away from the bank's goal. But there is an argument for letting this happen in order to build greater flexibility in the Fed's tool kit for responding to the possibility – some would say, the likelihood – of a significant growth downturn down the road.
For that to make sense, the Fed would need to be confident that the potential benefits justify the costs and risks. One of the biggest concerns is the risk of future financial instability. That threat will increase if, in the next year, Congress and the administration fail to agree on new pro-growth initiatives (an infrastructure program, for example).
To adapt an image from the world of magic, the Fed is examining whether it can pull another rabbit out of an overused (some would say abused) hat. Realistically, the best it can hope for is to again redirect attention in a way that allows the asset channel to replicate some of the outcomes that more genuine and targeted policy approaches would deliver; and to do so in a way that limits economy-wide distortions. The risk is that neither of these two issues materialize, leaving the central bank even more vulnerable to reputational risk and political interference.
Although the review could end up producing a less substantial action agenda than some of the central bankers might wish, it will highlight yet again an inconvenient reality: As discomforting as it is for the Fed, it and other central banks will have to continue to operate in a non-first-best world that is not of their making, that may persist for a while and that increasingly exposes them to a no-win environment.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. His books include “The Only Game in Town” and “When Markets Collide.”
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