Prices should no longer be targeted by the Fed

More On: Economics

Monetary policy cannot undo the damage caused by negative supply shocks such as war or government shutdowns caused by a pandemic.

First in more than three years, the Federal Reserve raised its interest rate target for the first time in more than three years. It has been predicting this move for a long time now. Preceding the announcement, there were still debates about whether and how much the Fed should "raise interest rates."

That debate is mostly a waste of time.

Everyone was talking about how much the Fed's Open Market Committee should do, but short-term interest rates were working hard to make the committee do what it should. There was a 0.05 percent rate on the three-month Treasury in November. By the end of February, it was 0.33 percent, down from 0.5%. A lot happened between February 1 and March 15. Overnight commercial paper rates went up from 0.16 percent to 0.33%. The one-week rate for financial commercial paper was close to the same as the one-week rate.

News stories often make it sound like the Fed only "controls" our economy's "interest rates." This isn't true, because the Fed doesn't just do this. However, it does try to make or break credit conditions based on its macroeconomic goals. There are many things the Fed has to do for Congress, but one of them is to "promote" price stability.

This is because inflation has been going up and breaking long-term records for the past few months. This also made the Fed do something. There was a good chance that the Fed would soon raise its target interest rates because of the rising price of food and other goods. It's still interesting when people talk about the Fed's congressional mandate.

The mandate is called the "dual mandate" because it says the Fed must keep prices stable and make sure everyone has a job. There are more than two variables in this expression, but it doesn't mean that there are only two. In other words, the mandate isn't very clear, and it gives the Fed so much power that it's hard for Congress to hold the Fed accountable.

Over time, the Fed thinks that price stability is when the rate of inflation averages two percent, but it won't say how it comes up with that figure. Is it 2% over the last six months? The last twelve? Is it two percent over some time? "Yeah, if we say so." That's what the Fed says under its "flexible form of average inflation targeting."

The mandate gives the Fed even more leeway to interpret its job goals, but the fact that job goals are in the mandate is even more of a problem for them. "Most economists would agree with the chair of the Federal Reserve that the level of employment is largely determined by factors that are not controlled by the Fed." This isn't a crazy idea, and other central banks often talk about it.

Either way, many economists have called for some kind of policy rule to make sure the Fed does what it's supposed to do. Others, including the Fed, have said that these efforts are too restrictive and make it hard for the Fed to do what it needs to do. So the Fed has to be able to change its policies, they say.

It's true that there is a policy option that would keep us from having to deal with so many unknowns, but there is another option. It could also be done by making a policy rule to do it. Congress could change the mandate that the Fed has to keep the economy growing at a reasonable pace of total nominal spending. This mandate could be changed by Congress.

Many people will think of this mandate as one that tells the Fed to keep an eye on "real gross domestic product" (NGDP). NGDP targeting has a lot of good things. It avoids, for example, making the Fed predict how much GDP will grow. It also frees the Fed from having to figure out what full employment might be. Instead, the Fed needs to keep the monetary conditions that lead to full employment.

An NGDP-targeting rule would also allow the Fed to deal with inflation, but in a much better way than they would be able to now. As a result, the Fed could act when there is too much spending growth, but not when there is an increase in the amount of money in the economy.

This would come in handy right now.

A war or a government shutdown because of a pandemic can't be fixed with money. These shocks cut down on the amount of goods in the economy, which makes prices go up. As a result, people will not be able to get the goods and services they need, and they will have even less money to buy what is available.

Current inflation is caused by both supply shocks and rising demand. It's hard to figure out how much of the rise in prices is caused by each of these things (in real time, at least). If you want to avoid this problem, you can try to keep your total nominal spending in check.

In order to keep nominal spending at the level that the Fed wants, the Fed only needs to change its policy.

They say that NGDP targeting is like central planning for people who love the free market NGDP targeting, on the other hand, does not require the Fed to set a target for the real level of goods and services in the economy. This is what they don't understand, though. To put it another way, the goal isn't to make sure people make a lot of different kinds of things like computers and cars.

Instead, the goal is to focus on how much we value those things. Importantly, the goal is to keep that nominal value in mind while letting prices move up or down, even if that causes inflation to fall below zero. This way, monetary policy doesn't hurt the economy as much as possible. (Monetary policy would be a neutral thing.)

Another good thing about NGDP targeting is that it would let prices fall when productivity rises, so people would be able to get more out of a growing economy more quickly. A rising price level is not, in fact, necessary for an economy to grow.

A quick count shows that NGDP targeting doesn't have a lot of policy unknowns, which makes it easier to do effective monetary policy. NGDP targeting also prevents the government from reacting to both negative and positive supply shocks in the wrong way. And it doesn't ask the Fed to set goals for things that it can't control or measure, like maximum employment or potential GDP. It would make the central bank less active, so it would be able to do a lot less to mess with the economy through money.

Members of Congress should ask Fed chair Powell about the benefits of NGDP targeting. Debating whether the Fed should raise its target rate for the next two months or three would be of no use at all. Instead, let's talk about how much the Fed should raise its rate.