Fed Should Target Spending, Not Inflation
The idea that what this economy needs is more inflation will sound odd to most ears, but a lot of smart people are voicing it. They’re right that we need looser money, but wrong about why.
The Federal Reserve has interpreted its mandate to promote “stable prices” to mean that it should shoot for an inflation rate of roughly 2 percent per year. The latest “core inflation” number -- which excludes energy and food prices because they’re more volatile -- was 1.68 percent. The Cleveland Fed estimates that the market expects inflation to average 1.55 percent over the next decade.
Some economists want a looser monetary policy so that the Fed hits its target, or even exceeds it. Within this group, some advocate above-target inflation temporarily as a way to help the economy, which they consider to still be depressed. Others say the Fed should permanently raise its target to 4 percent.
Their reasoning is that faster inflation today is a way to reduce real interest rates when nominal rates, being roughly zero, can’t fall. Faster inflation should also spur spending on both consumption and investment because it raises the price of just leaving money idle. These effects would stimulate the economy in the short run.
The advantage of a permanently higher inflation rate is that it would raise nominal interest rates: If you expect higher inflation, you’ll want to charge a higher interest rate to compensate for it. So in future recessions, the Fed will have more room to reduce interest rates before hitting zero. A 4 percent target would come with some costs. Taxes on capital aren’t adjusted for inflation, for instance, so faster inflation would make those taxes higher and more distortionary in real terms.
But the main reason the Fed shouldn’t adopt a higher inflation-rate target is that targeting any inflation rate at all is a mistake.
Instead, the Fed should target nominal spending so that the total amount of dollars spent in the economy grows by about 5 percent a year. How much of that spending growth would represent inflation and how much would represent real economic gains is out of the Fed’s control, so it shouldn’t seek any particular mix.
Compared to an inflation-rate target, a nominal-spending target would respond better to changes in productivity. If the Fed were following a strict inflation-rate target, reduced productivity would force it to tighten money when the economy is suffering, and higher productivity would force it to loosen money when the economy is booming. If the Fed were following a nominal-spending target, it would neither loosen nor tighten: All that would change is the ratio of inflation to real growth.
The arguments for higher inflation are actually better arguments for higher nominal spending. People consume and invest more when they expect higher inflation, but also when they expect higher rates of real economic growth. In other words, it’s higher expectations of nominal spending that stimulate them.
Low interest rates don’t prevent the Fed from loosening money, as several rounds of quantitative easing (not to mention other countries’ currency depreciations) show. So we don’t need a higher inflation-rate target to get higher interest rates that the Fed can then lower in future recessions. And we certainly shouldn’t adopt a higher target just because the Fed is uncomfortable changing the way it operates.
To return to reality for a moment: The Fed isn’t hitting its 2 percent inflation target now, let alone coming close to 4 percent. People who think the economy remains depressed -- and think it’s depressed largely because money is too tight -- have to urge the Fed to do something different. In some sense, we have to push the central bank out of its comfort zone.
It may be that a nominal-spending target is further outside that zone than a higher inflation-rate target. But remember that inflation is extremely unpopular. A deliberate Fed policy of raising inflation rates, especially permanently, seems likely to yield a backlash -- or even a frontlash that keeps it from happening in the first place. A Fed policy that seeks to raise incomes and spending seems likely to meet less resistance.
And it seems to me that higher incomes and spending are what we should really want in today’s circumstances. Faster inflation is valuable to the extent that it produces higher nominal spending, and higher nominal spending would be valuable even if it didn’t involve more inflation.
The inflationists generally argue that the Fed needs a better communications strategy. They should take their own advice.
To contact the author of this column: Ramesh Ponnuru at firstname.lastname@example.org.
To contact the editor responsible for this column: Timothy Lavin at email@example.com.