Federal Reserve inflation targets may affect you

Many people take umbrage at the mention of a central bank trying to achieve some level of inflation

June 6, 2014 

There is a debate about Federal Reserve policy right now that may strike many non-economists as one about how many angels can dance on the head of a pin. But it's important if you're concerned about how much things cost and how that influences our larger economy.

The debate is over the virtues of our central bank setting a target for the "price level," a generic way of setting the level of the Consumer Price Index, versus trying to achieve a specific growth rate for inflation, or the annual change in the CPI.

I am not convinced there is much real-world difference in this distinction between the absolute level and the rate of change of that level. But some economists far better educated and experienced than I am think the distinction is important. These include Narayana Kocherlakota, president of the Minneapolis Federal Reserve Bank, who, in the Fed's complicated rotation system, is a voting member of the policy-making Federal Open Market Committee every third year including 2014. Several other very distinguished economists make the same argument.

The whole context for this is that central banks around the world are running scared of deflation - or a crippling drop in consumer prices. The antidote is to increase their nations' "monetary bases," the combination of currency and bank reserves that is the foundation of a nation's money supply. In other words, they are implementing the sort of "quantitative easing" that the Fed has followed for five years.

In any exercise of monetary policy, the question is whether the central bank should operate on a seat-of-the pants basis of pure discretion or follow pre-announced goals for some measureable variable, such as interest rates or the money supply - the commonly suggested benchmarks in the 1950s through 1970s. Today, possible targets include an inflation rate, the level of the CPI or "nominal GDP" (the level of output of goods and services before adjusting for inflation).

Many people take umbrage at the mention of a central bank trying to achieve some level of inflation. Isn't it the job of the Fed to tame inflation? Wasn't a failure of Fed policy responsible for the tripling of average consumer prices between 1967 and 1982? Why should a central bank want any inflation at all?

The answer is that most economists see low, stable and predictable inflation as pretty benign. And the general public agrees. If you ask people if 1 percent to 2 percent inflation is a problem, most don't see it as a serious one.

Indeed, some economists see a bit of inflation as a lubricant that eases some necessary adjustments - spurring demand lest prices go up later. Many economists and economic historians see deflation as a worse threat - stifling demand lest prices drop further.

That deflation can smother economic output, and thus push up unemployment, is the accepted wisdom in the discipline.

The Great Depression, when prices fell sharply from 1929 through 1933 in the face of Fed tightness is one example cited. Japan in the 25 years since its asset-price bubble burst in 1989 is another. Near-panicked calls for the European Central Bank to act to stave off deflation made by some are based in a fear of falling into the sort of malaise Japan has suffered.

That view isn't held by all. At least two economists, beg to differ. Lee Ohanian at UCLA and Harold Cole at Penn have looked at deflations, both historically and across a range of other countries, and conclude that the conventional story is wrong. Deflations, they find, do not automatically trigger recessions with high unemployment.

Their view remains a minority one.It certainly is not shared by Kocherlakota. He laid out his reasoning in a May 21 speech, available on the Minneapolis Fed website. An excellent exposition of it by a sharp UC-Berkeley grad student may be even better for many people. Enter "Carola Binder" and "Kocherlakota" into your favorite search engine.

The condensed story is that the he sees continuing high levels of unemployment as the nation's most serious problem, a tragic one. And he thinks a loose monetary policy can be effective in correcting this.

There is much irony. The assumption that there is a direct tradeoff between inflation and unemployment is the core of the "Phillips Curve" laid out by a New Zealand economist a half century ago. It fit hand and glove with the broader theories of John Maynard Keynes.

But as policies to reduce unemployment led to inflation in the 1970s, that belief came under sharp attack by a group of young economists with a theory based on "rational expectations."

Rational expectationists argued that the Phillips Curve was a fallacious trap. While Kocherlakota is too young to have participated in the heyday of this movement, he was solidly in the camp of economists who criticized Keynesian policies. Now he seems to embrace them.

He is an economist I respect, in great part because of his past efforts to emphasize areas of agreement within the discipline. But while I share his general concerns, I am much less optimistic about the efficacy of continued suppression of interest rates in reducing unemployment. I see more dangers of this easy money inflating bubbles in the prices of stocks, farmland and even houses.

Read Kocherlakota's speech and Binder's gloss on it. Follow what is happening with the Bank of Japan and the ECB. And hold onto your hat.

Write Ed Lotterman at boise@edlotterman.com.

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