Given the spectacle of this year’s presidential race, it is easy to overlook the parallel drama in the world of central banking. But when the monetary priesthood gathers Thursday for its annual seminar-cum-summer camp in Jackson Hole, Wyo., heretics will stalk the halls. The proper objective of a central bank is no longer a settled issue.
For more than a third of a century — arguably, since Paul Volcker’s appointment to the Federal Reserve chairmanship in 1979 — the central bank has focused on a single goal: to reduce and stabilize inflation. Legally, it has been required to target full employment, too, but from Volcker’s arrival until the 2008 crash, this second objective was cheerfully ignored on the ground that the best thing for jobs was to crush inflation. In the United States and in most advanced economies, central banks embraced an inflation target of 2 percent. It was as though they had discovered a miracle drug, and their prestige soared accordingly.
Since 2008, however, this consensus has been cracking. To begin with, a minority of economists blamed inflation-targeting for the mortgage bubble: Obsessed with stabilizing prices, the Fed had ignored the mission of the early central banks, which was to stabilize the financial system. There was much truth to this criticism, but it never won over a majority of experts. Central bankers retorted that steadying finance was the job not of monetary policy but of regulatory controls. Far from questioning the wisdom of an inflation target, the Fed hardened its commitment to the 2 percent goal, switching from an unannounced target to an explicit one.
The next attack on the inflation-targeting consensus came from so-called NGDP targeters. This school argued that the Fed should aim to deliver an agreed-upon rate of nominal growth — that is, growth of real GDP, plus inflation. For example, the NGDP target might be set at 4 percent, reflecting a view that the sustainable growth rate of the economy was 2 percent per year, with the desired rate of inflation contributing another 2 percent.
Again, there was much to recommend this heresy. In boom times such as the tech bubble of 1999 or the mortgage bubble of 2005-06, an NGDP target would have driven the Fed to hike interest rates until inflation fell below 2 percent, which would have cooled Wall Street and reduced the pain of the ensuing crashes. In bad times, an NGDP target would make a nifty contribution, too. If growth fell to, say, zero, the Fed would be committed to stimulating the economy until inflation rose to 4 percent. That commitment would cause families and businesses to expect more inflation, which would in turn encourage them to spend rather than save, reinforcing the Fed’s stimulus. But despite its cogent arguments, the NGDP school also failed to win the day. Its case was off-puttingly complex. And a commitment to cap economic growth would not make the Fed popular.
So now comes a third attack on the central-banking consensus, conceptually less radical and therefore politically more potent. This holds that an inflation target is a noble thing, but that 2 percent is not high enough. The idea was first championed by the research department of the International Monetary Fund, a respected bastion of the central-bank establishment. Last week, John Williams, president of the Federal Reserve Bank of San Francisco, came close to endorsing it, throwing in some kind words about NGDP targeting for good measure. The heretics are now inside the citadel.
Would a small adjustment in the inflation target — from, say, 2 percent to 4 percent — matter to ordinary citizens? The obvious advantage is that central banks would have more scope to fight recessions. The Fed sets its lending rate at a level that reflects the appropriate “real” interest rate for the economy, plus inflation; so if the real rate should be 3 percent and inflation were 2 percent, the Fed’s lending rate would be 5 percent. But if the Fed raised its inflation target and delivered annual price increases of 4 percent, then the same economic conditions would lead to a Fed lending rate of 7 percent. The higher this nominal Fed rate, the more room the Fed will have to cut it in a recession. By switching to a higher inflation regime, therefore, the Fed might not have to resort to less effective tricks such as quantitative easing.
But raising the inflation target would have a further consequence — less noted but as interesting. It would underscore how the internationally celebrated 2 percent target is no divinely ordained rule; it is shockingly arbitrary. The magical 2 percent marker could just as well be 3 percent or 4 percent, and the dirty little secret of central banking is that the gains from stable prices are difficult to demonstrate. Despite the brilliance of its practitioners, monetary policy is not a settled science. It is an improvised experiment.