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HomeMarketShould the Fed Target 3% Inflation? Now's Not the Time.

Should the Fed Target 3% Inflation? Now’s Not the Time.

If the Fed were ever to revise its inflation target, it could do so only at a time of institutional strength, writes Stephen Miran.

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Stefani Reynolds/Bloomberg

About the author: Stephen Miran is co-founder at investment manager Amberwave Partners and former senior advisor for economic policy at the U.S. Treasury, 2020-21.

With consumer prices in excess of 15% above prepandemic levels, the Federal Reserve has a problem on its hands. While the Federal Reserve Act defines the Fed’s goals as “maximum employment, stable prices, and moderate long-term interest rates,” it doesn’t give more detail. The Fed is left to interpret its own price-stability mandate, and has decided it means 2% annual increases in prices.

Inflation has been stubbornly high due in large part to historically miscalibrated fiscal and monetary policy. It is unlikely to quickly return to 2% while wages are still growing about 5%. Unfortunately, without bringing down wage inflation, it will be difficult to bring down price inflation. That’s why economists usually believe it takes a recession to kill inflation, as rising unemployment will temper wage hikes.

But unemployment and recessions have enormous human costs, with long-term consequences for people’s careers, health, and family lives. To avoid these costs, there has been a spate of high-profile calls to raise the Fed’s inflation target. For example, former International Monetary Fund Chief Economist Olivier Blanchard has called for an official 3% target, while Nobel laureate Paul Krugman has suggested the Fed surreptitiously change its target to 3% “without admitting that we’re doing it.” Harvard’s Jason Furman and the Peterson Institute’s Joseph Gagnon have also called for a higher target.

The problem with raising the target officially is that the bond market will likely believe it’s only the first such change. After all, the Fed just changed its framework two years ago to “flexible average inflation targeting.” Its plan was to make up for past slight shortfalls in inflation, as though anyone could measure inflation precisely enough that a 0.3% miss was meaningful. This new framework contributed to the Fed making the largest monetary-policy error since the 1970s. If the Fed now changed the target to 3%, why would it stop there? As unemployment worsens, the pressure from politicians will only grow. Then how long until 5%?

The market will be correct to infer that once the taboo is broken, it becomes easy to move the target at will. The result will be meaningfully higher long-term interest rates, as investors demand a large risk premium for holding bonds. Higher long-term rates will hamper long-term economic growth, make investing in businesses and purchasing homes more expensive, and erode the fiscal solvency of the U.S. government, thus making us all poorer.

Krugman’s suggestion is even worse, since it replicates these market outcomes (though more slowly) and undermines the popular legitimacy of the Fed. If the Fed is to have the flexibility to interpret its mandate how it sees fit, it should do so honestly and in the open, with full democratic accountability. Lying to the public and pulling a fast one is unacceptable and will only encourage more anger against the institution. The Fed is already on thin ice, and if it takes this path, it risks Congress reopening the Federal Reserve Act or a future president removing board members for cause.

If the Fed were ever to revise its inflation target, it could do so only at a time of institutional strength—when inflation has been for a long time at or slightly below 2%, and credibility is rock solid. Whatever the merits of a higher inflation target, this is obviously not the time to adopt one.

Guest commentaries like this one are written by authors outside the Barron’s and MarketWatch newsroom. They reflect the perspective and opinions of the authors. Submit commentary proposals and other feedback to ideas@barrons.com.

Credit: marketwatch.com

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