The Price Stability Act of 2022, a bill before the House Financial Services Commission, would transform the Federal Reserve’s dual mandate into a single mandate. Instead of maximum employment and stable prices, the Fed would only aim for stable prices. Is this a welcome change? Without approving or condemning the bill, we can explore its costs and benefits.
The invoice does not specify what is meant by “stable prices”. For now, we can interpret it as an inflation target. Whether the actual number is 2 percent or 0 percent makes little difference. As long as price increases are small and predictable, many different target numbers may work.
Although the Fed currently has an “average” inflation target of 2%, it is self-chosen and therefore cannot commit itself. The Fed is essentially a judge in its own case. “We investigated and determined that we did nothing wrong,” they might say. The imposition by Congress of an inflation target at the Fed could have teeth.
A binding result target is better than the unverifiable pseudo target the Fed has now. According to the Fed’s interpretation, the target is asymmetrical: they are comfortable with inflation above 2 percent but not below 2 percent. Markets rightly question the Fed’s credibility, which affects its ability to implement monetary policy.
Creating a predictable growth path for the dollar’s value has definitive economic benefits. Most economists think of “driving forward” (central banks communicating their intentions for future policy) in terms of interest rates. This is wrong. Interest rates are the prices of capital, and therefore time. Central banks shouldn’t mess with them. The forward guidance on the price level, on the other hand, is very useful. Create a stable base for economic activity by giving trade a yardstick. No one could effectively prepare for a race if the definition of the meter changed all the time. A similar truth holds true for economic activity. The unpredictability of the price level can lead to short-term underproduction or overproduction and long-term underinvestment. Conversely, credibly engaging in a growth path for dollar purchasing power creates a solid foundation for markets to provide full employment today and could have beneficial effects on growth tomorrow.
But an inflation target has some drawbacks. Imagine experiencing a large-scale productivity slowdown, which makes it a little harder to turn inputs into outputs than expected. This is an example of what economists call a negative supply shock. Prices across the economy would rise, which means the dollar’s purchasing power would decrease.
Supply problems create inflation. A Fed that aims for inflation would be forced to contract total spending (aggregate demand) to bring inflation down. But that means that real output and employment, already damaged by the supply shock, would take a second hit. The central bank will reach its inflation target at the cost of exacerbating the economic downturn.
A Fed mandate focusing on nominal spending growth rather than inflation could avoid this problem. Aggregate demand means nominal GDP: output valued at current market prices. In the event of a supply shock, a Fed aiming for spending growth would not need to contract aggregate demand to reduce inflation. On the contrary, it would allow inflation to block some of the damage from the slowdown in productivity. Production and employment would continue to decline. Difficulties on the supply side make it inevitable. But the Fed would not aggravate the damage. Indeed, an expenditure growth target seems close enough to first-best policy. The greater scarcity of goods compared to money means this the price of money should go down. Inflation, in this case, reveals an excess of money over goods. It has no independent negative consequences on well-being.
An expenditure growth target also tends to ensure long-term price stability. Supply shocks are usually temporary. When productivity problems are resolved and production returns to the trend, prices are resolved too. Therefore, an expenditure growth target could also be justified by a price stability mandate alone.
An inflation target is not as good as an expense growth target. But that doesn’t mean that an inflation target is undesirable. We rarely get our first-best policy pick. The second best may be all we can hope for given the constraints of the political system.If the choice is between an inflation target and nothing, there are strong reasons to prefer an inflation target. We need to subject the Fed to results-based rules. Discretion in monetary policy works poorly and it is also difficult to reconcile with the rule of law.
Politics is compromised. Half a loaf is better than no loaf Price stability is the half loaf of monetary policy rules. It seems silly to go hungry simply because haute cuisine is inaccessible.