It might seem a bit nit-picky to say the Federal Reserve needs to change how it operates when inflation is 2.3 percent, unemployment is 3.9 percent and median household incomes, adjusted for today’s prices, have hit an all-time high.
But it really isn’t when the Fed hasn’t figured out how to deal with a world in which our problem isn’t that inflation might get too high, but rather that interest rates will stay too low. That’s been the case ever since the financial crisis hit 10 years ago. At first, the Fed was too busy just trying to prevent another Great Depression to think too much about these longer-term issues, but lately it’s been basking in the glow of what Fed Chair Jerome H. Powell justifiably called “a particularly bright moment” for the economy instead of worrying about whether the way it’s doing things still makes sense.
Now, the Fed has always had a simple job that’s hard to do. It’s supposed to keep the economy going a responsible 55 mph by stepping on the gas when unemployment starts to go up, and on the brakes when inflation does. What happens, though, when the economy barely needs the brakes anymore? When such a big shock hits the economy that the Fed only needs to raise rates eight times over the course of 12 years? When, even in the good times, the economy is expanding so slowly because of the graying of the population and stagnant productivity growth that inflationary pressures are de minimis? And when the historical relationship between lower unemployment and higher inflation is so weak that, as it projected just the other day, the Fed believes it can keep unemployment at 3.5 percent — a full point below the level that’s supposed to neither speed up nor slow down prices — without inflation getting above 2.1 percent? Well, in that case, we’d live in a world of permanently lower interest rates.
That matters because, to extend the car analogy, imagine if your ability to step on the gas depended to a certain extent on how much you’d used the brakes in the past. That’s the case with the Fed: If it doesn’t increase interest rates a lot, then it won’t have much room to cut them when the economy does get into trouble. It’s true, of course, that it can do other things to try to stimulate the economy when it can’t cut interest rates anymore — like promising not to raise rates for a long time, or buying bonds with newly printed money — but these aren’t quite as effective, and are much more politically contentious options. It’d be a lot better if the Fed didn’t have to resort to them next time.
Unfortunately, though, it’s almost certain that it will. The Fed, after all, only expects to raise rates to a little more than 3 percent the next few years, but even that, according to markets, might be enough to cause a downturn. Which, considering that the Fed has had to cut rates by an average of 5 percentage points to fight past recessions, would mean that interest rates would get back down to zero, and it would have to go back to using its unconventional tools.
What the Fed needs, then, is a policy framework that gets interest rates up and keeps them there. Its 2 percent inflation target just isn’t getting the job done. A 4 percent target might, or, if that was too much, maybe a more flexible 2 percent target that tried to make up for any past shortfalls by letting prices go up by more than that later so that inflation averaged 2 percent over the course of the business cycle. But something needs to change. Otherwise, interest rates are going to keep falling to zero every time there’s a recession, recessions are going to keep being worse than they need to be because the Fed will have trouble doing enough to help the economy, and recoveries are going to keep being slow for the same reason.
It’s understandable that the Fed wouldn’t want to do this when things are going so well now — and, in fact, are doing so in no small part because of how successful their 2 percent target has been at stabilizing prices. Indeed, that’s one of the reasons unemployment has been able to fall so far without inflation going up that much. It’s a real victory over the problems that plagued us in the 1970s, but we have new ones now. They require new thinking.
The economy’s particularly dark moments will outweigh its bright ones if we don’t realize that.