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Tags: fed | inflation | target | spending

Why Fed Should Ditch 2% Inflation Target

Why Fed Should Ditch 2% Inflation Target
(Feng Yu/Dreamstime)

Peter Morici By Tuesday, 18 June 2019 08:57 AM Current | Bio | Archive

The Federal Reserve is charged by Congress to accomplish full employment and stable prices.

For economists, these objectives pose a tradeoff, and the Fed targets 2% inflation as a compromise.

All this is premised on economic theories rendered obsolete by the globalization of many goods and services markets, capital mobility, and resulting wage arbitrage.

The Phillips Curve postulates that as unemployment falls, workers get more bargaining power and push up wages and prices. Economists believe near-zero inflation is not sustainable because as average inflation gets too low, prices for discretionary items such as new cars and dry cleaning could actually fall - this would make businesses in those industries reluctant to invest, and plunge the economy into recession.

Currently, with unemployment near historic lows, U.S. inflation remains fairly tame.

With Chinese growth increasingly challenged, competitors elsewhere in Asia eager to snatch its manufacturing export industries. and the EU stuck in a malaise, U.S. businesses that face international competition are hard pressed to raise prices and pass along wage increases. Most pressure to push U.S. inflation up to 2% appears to be from the recent tariffs and international oil markets. The latter are aided by U.S. restrictions on new pipeline construction that would better move shale oil to refineries, sanctions against Iraq, the meltdown in Venezuela and the recent Russian-OPEC alliance to manage oil production.

None of those have much to do with domestic labor markets.

Four other factors also have unhinged inflation from the observed unemployment rate.

First, the observed unemployment rate, 3.6%, may not reflect a lot of hidden slack in labor markets.

During Barack Obama's presidency, adult labor force participation fell dramatically, helped by more generous Medicaid, food stamps, and Social Security disability benefits. The Trump Administration is tightening up these programs as it can and that is pushing prime-age adults back to work.

Second, more seniors are working these days because they are healthier than their parents were, and due to the demise of many defined-benefit pensions and the low interest paid on CDs and high grade bonds.

Third, the increasingly prominent technology sector uses fewer buildings and machines to create value than old-line, heavy manufacturing did. Software and autos both require expensive R&D but making more copies of a new app does not entail the same costly capital investment as increased demand for SUVs.

Fourth, Amazon.com and smartphone apps permit consumers to compare prices more easily, plus consumers are less loyal to big brands, limiting the ability of those businesses to increase prices.

In addition, economists believe clarity from Fed policymakers about future plans for interest rates can provide an anchor for inflation and encourage business investment. Except when the Fed expresses its policy intentions, it usually cautions future actions will depend on events as those develop. Earlier this year, the Fed scotched plans to raise interest rates further in response to stock and bond market turbulence - such behavior make the Fed's communications about policy intentions nearly useless for long-range business planning and investment.

Influential macroeconomists employ models that reduce the U.S. economy to a handful of equations - with little or no consideration of the above mentioned forces. Some purport to show if the Fed would merely communicate a preference for inflation above 2%, the economy would get more inflation and stronger growth.

That's silly. Instead, it would be better for the Fed to target a growth rate for overall nominal spending at 4.5% or 5% - that adds up to 2.5% to 3% for real growth and 2% for inflation. That would imply a target rate of inflation above 2% when growth is subpar and below 2% when the economy is robust.

The Fed should take some unconventional steps to boost spending as needed. It could offer seniors and others access to interest-bearing accounts it now limits to banks, hedge funds, and money managers - when spending is slack, inject cash directly into consumer accounts. And it could purchase state and municipal bonds for new infrastructure projects as the economy slows.

Spending, not inflation, drives growth and prosperity and that's where the Fed should focus.

Peter Morici is an economist and business professor at the University of Maryland, and a national columnist. He tweets @pmorici1

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Spending, not inflation, drives growth and prosperity and that's where the Fed should focus.
fed, inflation, target, spending
Tuesday, 18 June 2019 08:57 AM
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