The FOMC cannot simultaneously commit to a specific policy and to being data-dependent.
The Fed should adopt a monetary-policy rule and stick to it.
I nflation is not driven by Russia’s invasion of Ukraine, nor by shortages or supply-chain problems. Widespread, persistent price changes, as we are seeing today, can only be caused by the Federal Reserve’s monetary policy. What can the Fed do to fix it?
In the short term, the Fed must continue to aggressively raise interest rates, which it had delayed doing for far too long. After near-zero interest rates and expanding the monetary base through quantitative easing (QE) for all of 2021, the Federal Open Market Committee (FOMC) failed to take action in early 2022, despite signs of persistent inflation.
In January, the FOMC made no adjustment to its monetary policy. It raised its federal funds rate target by a mere 0.25 percentage points in March. In May, the FOMC raised the federal funds rate target by half of a percentage point. It was not until June, after the Bureau of Labor Statistics reported that consumer prices had grown 8.6 percent year-over-year, that the FOMC finally changed course, raising its federal funds rate target by 0.75 percentage points. Even that is not enough. The FOMC’s own projections show that inflation will persist above the long-run target of 2 percent through 2024.
To affect the public’s expectations of future inflation, the Fed must continue raising interest rates, not just in the half-point increments as it had previously indicated, but with larger hikes like the one in June. Only such aggressive actions can signal that the FOMC is taking inflation seriously and is committed to stabilizing the price level.
As a longer-term solution, the FOMC should consider adopting a predictable rule to guide its monetary-policy decisions. A rule-based approach makes policy more predictable and helps set the public’s inflation expectations.
Expectations play an important role in the Fed’s economic models, and chairman Jerome Powell has said that expectations are themselves “an important driver of actual inflation.” Powell has also explained that Fed policy was “never on a preset course and will change as appropriate in response to incoming information.”
But the FOMC cannot simultaneously commit to a specific policy and to being data-dependent. The more committed it is to a given policy, the less flexibility it has to adjust policy in response to changing economic conditions.
Throughout 2020, Powell’s mantra was that the Fed would do everything in its power to support the economic recovery. In early 2021, Powell repeatedly stated that the Fed would give “ample warning” before any changes in policy. By fall, however, Fed officials realized that high inflation was more persistent than they had previously expected. The FOMC raised its inflation projections and stopped describing inflation as “transitory.” Since committing to a stable policy, the data had changed.
At this point, Powell had to choose: Would he encourage the FOMC to move quickly to raise interest rates and stave off inflation, or would he stick to his commitment to move slowly and provide ample warning of changes in policy? Powell chose to move slowly and allow higher inflation, although he probably underestimated how high it would actually get.
If Powell is serious about setting expectations while remaining data-dependent, he should urge the FOMC to commit to a policy rule rather than a specific policy. A policy rule specifies a policy response given the observed data. If the data change, so does the policy. But the policy rule remains fixed. With a policy rule, people can more easily form expectations because they know that policy will respond in a predictable way to changes in the economic data.
There are several potential rules to choose from. The FOMC might target a specific rate of inflation, although the Fed’s dual mandate requires it to consider both price stability and employment. The Taylor rule, developed by economist John Taylor, is a formula that calculates what interest rate the FOMC should set based on the current rates of inflation and unemployment (or economic growth). While there are several variations, a standard Taylor rule most likely would have encouraged the FOMC to cut interest rates more quickly than it actually did going into the pandemic and raise them more quickly starting in late 2020, which likely would have helped promoted the recovery while limiting inflation thereafter.
Another option is to target the growth rate of total spending in the economy, described by economists as nominal gross domestic product (NGDP). With an NGDP level target, the Fed would keep total spending in the economy growing on a pre-determined path by increasing money growth when the economy was below trend and slowing money growth when above trend. Such a policy rule might be adopted as a strict commitment or merely a rule of thumb to help set expectations and guide FOMC decisions.
There is also a difference between rules that target an outcome in a specific year and rules that specify the target path over time. Prior to 2020, for example, the FOMC had a stated target of 2 percent annual inflation, measured by “core” personal consumption expenditures (PCE). That is different from targeting the path of the price level at 2 percent, where undershooting the target in one year would require overshooting the target in the next year, or vice versa, with inflation averaging 2 percent per year in the long run.
In August of 2020, the FOMC changed to an average inflation target (AIT), which — one would presume — aims for an average of 2 percent inflation over time. For example, following below-target 2020 inflation of 1.48 percent, the FOMC would, following Powell’s description, “aim to achieve inflation moderately above 2 percent for some time” to catch up for the effect of sub-2 percent 2020 inflation.
Unfortunately, the FOMC implemented AIT in an asymmetric way. Given that 2021 inflation was 4.89 percent, the policy seems to imply that the FOMC will bring inflation down below the target in 2023 or 2024 to maintain a long-run average of 2 percent. However, the FOMC does not intend to bring inflation down below the target. As Powell described, “There’s nothing in our framework about having inflation run below 2 percent.” Instead, the FOMC projects inflation to exceed the 2 percent target through at least 2024, never returning to the previous 2 percent growth path. This deviation from the expected policy has caused the Fed to become less credible in the eyes of the public, which will make it more difficult to influence future inflation expectations.
To get inflation back on track, the Fed should commit to following a monetary-policy rule. Such a rule would help the public form reasonable inflation expectations without preventing the Fed from responding appropriately to changing economic conditions. Given the state of inflation, however, the Fed will have a hard time reestablishing its credibility regardless of which rule it chooses.
At the very least, the FOMC should drastically raise interest rates to get inflation under control and help set the public’s expectations of future inflation. Some FOMC members are discussing raising their interest rate targets at their meeting next week by 0.75 percentage points, although financial market investors may now be expecting a full one-point raise. The FOMC projects the federal funds rate to be in the range of 3.1 to 3.9 percent by the end of the year, but perhaps 5 percent or higher may be needed to calm public expectations. Even that would be far below the rates above 20 percent seen in the early 1980s.
The FOMC should consider a monetary rule. A Taylor rule or NGDP target would have supported the pandemic recovery without disastrous inflation. Adopting a monetary rule would make it easier for the Fed to regain its credibility and maintain it in the future.