ECONOMICS Bloomberg Business October 12, 202030
GETTY IMAGESabove target will seem reckless; why, inflation
hawks are sure to ask, should the Fed risk igniting
high inflation after it’s already achieved its purpose
of eradicating deflationary psychology?
Members of the FOMC may be tempted to raise
interest rates quickly after inflation has gone above
2%, rather than let the rate average 2% over any
meaningful period. The consensus on deliberate
overshooting already shows signs of cracking.
Robert Kaplan, president of the Federal Reserve
BankofDallas, dissented at the September meet-
g ofthe FOMC from the promise to keep rates low
leastuntil inflation hits 2%, preferring “greater
policyflexibility.”
It’shard to credibly promise to do some-
thingthat will seem wrong to you when the
e comes to act—an insight that helped
a Nobel Prize in economics in 2004 for
FinnKydland, now at the University of California
atSantaBarbara, and Edward Prescott, now at
Arizona State University. (For a political analogy,
consider Republican Senator Lindsey Graham of
South Carolina, who promised not to fill a Supreme
Court vacancy in a presidential election year, then
thought better of his pledge when the time came.)
Still, Powell and the rest of the FOMC need to
convince the markets and consumers that they
really, really mean it this time. A firm rule can
help by tying bankers’ hands. When high inflation
was the concern, University of Chicago economist
Milton Friedman advocated a “k-percent” rule that
said that if the Fed committed to increasing the
money supply by the same low percentage each
year, inflation would be mild and predictable. Fed
Chair Paul Volcker, the giant who broke the back
of inflation in the early 1980s, professed to follow a
money-growth rule, though in practice there were
dramatic fluctuations in the money supply.
Alan Greenspan, who succeeded Volcker, was
not a rules guy. He cultivated the image of an
inscrutable maestro and said in a 1988 speech, “I
guess I should warn you, if I turn out to be par-
ticularly clear, you’ve probably misunderstood
what I said.” Ben Bernanke and Janet Yellen, thenext two Fed chiefs, were economic scholars
from Princeton and the University of California
at Berkeley, respectively, who believed rules
enhanced credibility. They targeted consumer
prices rather than money growth. The Fed, which
had informally aimed for 2% annual inflation since
the Greenspan era, made itself strictly account-
able for achieving 2% by publicly adopting it as a
target in January 2012.
To the consternation of Fed officials, the central
bank’s favored measure of inflation has come in
below 2% in all but 15 of the 103 months since the
2012 pronouncement. Low interest rates are part
of the problem. The Fed can’t keep inflation from
falling when the economy is weak because there’s
no room to cut rates to rev up growth. In contrast,
it can keep inflation from getting too high by rais-
ing rates to cool growth. Because of that asymme-
try, inflation readings below 2% have been far more
common than readings above it.
Powell, a former investment banker, Treasury
Department official, and private equity investor,
telegraphed his dissatisfaction with the status
quo in August 2018 at the Jackson Hole confer-
ence. It was six months into his term as chair
after six years as a board member. He questioned
the usefulness of two key inputs into the Fed’s
interest-rate-setting formula: “r-star,” the neutral
rate of interest that neither accelerates nor retards
growth, and “u-star,” the lowest the unemploy-
ment rate can go without igniting excessive infla-
tion. Unlike the stars that navigators once steered
their ships by, Powell said, r-star and u-starmove
around, making them unreliable guides. H
expressed admiration for how Greenspantru
his own hunches about the U.S.econo
rather than the “shifting stars.”
“I don’t think people understan
how different a worldview”Po
brought to the chairmanship, says
Adam Posen, president of thePeterson
Institute for International Economics.“Bernanke
and Yellen wanted to make monetarypolicy
scientific,” says Vince Reinhart, chief economistof0pt
timFkWhat the Fed
Is Up Against
Inflation is low despite
low unemployment and
interest rates; investors
predict more of the sameInflation*Fed’stargetUnemployment1/2012 8/2020 Q1 2012 Q3 20203%2 1 0 e l s n
Fed’sestimateof
full-employment
unemployment rate12%963