The Fed versus price stability

Robert Heller Former member of the US Federal Reserve Board of Governors There is a big difference between the Federal Reserve’s mandate to maintain “stable prices” – as enunciated in the Federal Reserve Act – and the Fed’s self-selected target of 2% annual inflation. So how is it that policymakers have managed to substitute the latter for the former? The term “stable prices” is self-explanatory: a bundle of goods will cost the same ten, 50, or even 100 years from now. By contrast, if a country experiences 2% inflation over a ten-year period, the same items that US$100 can buy today will cost US$122 at the end of the decade. After 100 years, the price tag will be a whopping US$724. In her recent Congressional testimony, Fed Chair Janet Yellen referred several times to the mandate of maintaining “stable prices”; but she mentioned the Fed’s 2% inflation objective twice as often. “US inflation continues to run below the Committee’s 2% objective,” she said, and the current “high degree of policy accommodation remains appropriate to foster further improvement in labour market conditions and to promote a return of inflation toward 2% over the medium term.” Does the Fed really want to increase annual inflation to 2%, such that the price level of the country will increase by more than 700% over the next century? Is that what Congress had in mind when it tasked the Fed with achieving “stable prices”? Former Fed Chairman Alan Greenspan knew that it did not. On July 2, 1996, at a meeting of the Federal Open Market Committee (FOMC), which was devoted to extensive discussion of the appropriate inflation target for the Fed, Greenspan posed a simple question: “Are we talking about price stability or are we talking about zero inflation?” he asked. “As we all know, those are two separate things.” The discussion quickly turned to the difficulty of measuring inflation accurately and the need to build in a “safety cushion” to avoid deflation. According to Greenspan, “Price stability is that state in which expected changes in the general price level do not effectively alter business and household decisions.” Yellen, then a Fed governor, was not satisfied: “Could you please put a number on that?” she asked. Greenspan did: “I would say that number is zero, if inflation is properly measured,” he replied. At the time of that FOMC meeting, the consumer price index was increasing at about 3% per year. Most of the discussion focused on whether the Fed should slow annual price growth to 2% or even lower, thereby consolidating the gains made in the difficult fight against inflation that policymakers had waged for the previous 15 years. Greenspan summarized the consensus: “…we have now all agreed on 2%…” Thus, the Fed’s 2% inflation objective was born. During the ensuing discussion, several FOMC members argued that the inflation rate might be reduced to less than 2%, but nobody argued that inflation should be pushed higher if a lower, but still positive, rate was achieved. Following the discussion, Greenspan exhorted the FOMC members to keep the discussion of the inflation target secret. “I will tell you that if the 2% inflation figure gets out of this room,” he warned, “it is going to create more problems for us than I think any of you might anticipate.” The official minutes of the meeting make no reference to the entire discussion of the inflation target, which took up several hours, and the FOMC never formally announced its 2% target for annual inflation until Chairman Ben Bernanke, Yellen’s predecessor, finally did so in 2012. The 2% inflation target now is at the forefront of FOMC decision-making. For example, while annual inflation stood at 0.8% in December 2014, the minutes of the January 2015 FOMC meeting refer several times to the Committee’s need to make “progress toward its objectives of maximum employment and 2% inflation” by maintaining a highly accommodative policy stance. Increasing the rate of inflation is now the stated objective of Fed policy. Congress did not give the Fed a mandate to pursue that goal. The Federal Reserve Act is explicit: the Fed should achieve “price stability” for the US currency, along with moderate interest rates and maximum employment. As long as inflation is somewhere between zero and 2%, the Fed should declare victory and leave it at that. Project Syndicate