Buoyed by prospects for stronger growth, central bankers on both sides of the Atlantic appear ready to tighten monetary policy despite having fallen short of their goal of 2% inflation.
Still, their continuing obsession with 2% inflation as a measure of policy success is troubling. After all, central bankers’ mandate is price stability and maximum employment — not price stability plus 2% and millions of able-bodied people not seeking employment or counting in the unemployment tallies.
Plainly, central bankers—having come of age during the hyperinflation of the 1970s and painful corrective measures of Paul Volcker and others—have decided price stability is impossible—2% is the best we can do—and genuine full employment is beyond the grasp of monetary policy.
Indeed, when the Fed embraced the 2% goal in 2012, it stated “the inflation rate over the longer run is primarily determined by monetary policy” but “the maximum level of employment is largely determined by nonmonetary factors.”
Economists fear inflation nearer to zero, because relative prices are constantly and abruptly changing with technology and consumer preferences, wages are inherently sticky on the downside, and credit contracts are generally set in nominal not real terms. Hence, businesses whose products’ relative prices are falling won’t be able to lower wages and meet debt obligations and will unnecessarily contract—hastening the next recession.
Moreover, inflation too high tends to be unstable—high beta. That makes assigning appropriate nominal interest rates for longer-term contracts too difficult and increases the rewards premium for financial and intellectual capital devoted to speculation, as opposed to expanding and improving the real economy.
In the simplest example, people buy bigger houses than they can afford or need, because they expect rising home prices to bail them out—indeed enrich them. However, as the housing bubbles of the early 1980s and late 2000s demonstrated, this behavior permits 20- and 40-somethings to become millionaires and billionaires by hawking structured securities to old folks in Florida but contributes little to real economic growth and ultimately begets a crisis.
The experiences of recent decades offer four salient lessons about central banking.
First, even by pumping trillions of dollars into financial markets, central bankers could not reach their 2% inflation targets but businesses selling products with falling relative prices were not much hurt. Some, like brick-and-mortar retailing and big oil, ceded employment but not because they couldn’t lower nominal wages or borrow at very low rates—rather Amazon AMZN, -0.08% and shale producers offered their customers better and more efficient alternatives.
Second, no matter how cheap money may be it can’t boost economic growth if new financial regulations inhibit banks from lending to businesses and households, and an array of government policies—for example, Medicaid, housing subsidies and food stamps even for adult men who refuse to seek employment—suppress labor-force participation.
Third, very cheap money, as surely as too much inflation, begets speculation and skews reward structures for our brightest young people toward careers in finance away from engineering with obvious consequences for bubbles and long-term growth. And putting the economy on the crutches of cheap credit enables politicians to put off structural measures—like tax reform, streamlining financial regulations, and curbing entitlement abuse.
Fourth, the additional income and wealth financial engineers enjoy comes at the expense of ordinary people. The processes may be complex but the economic pie gets arbitrarily re-divided in favor of the young at the expense of the elderly, who rely on interest from CDs and other fixed-income investments, and in favor of financial engineers, speculators and the indolent benefiting from government programs at the expense of those that make the pie bigger—real engineers, entrepreneurs and hard-working folks who invest in skills.
The minority of voices among central bankers, for example James Bullard, suggest even the gradual pace of monetary tightening now contemplated should be stemmed owing to the need to further support the economy.
However, it might be more prudent for central bankers to aim for inflation of 1.5% with a mind toward gradually lowering that target over time to 1% or even zero. That would be more just—if you consider taxing grandma to aid Goldman Sachs GS, -0.14% unjust—and better for growth—if you consider cultivating more engineers, entrepreneurs and skilled workers and fewer financiers a good thing.