In recent months, it has become clear that the Federal Reserve’s monetary policy is too expansionary to achieve its policy goals, as the Fed was too slow in ending quantitative easing and raising interest rates. In the fourth quarter of 2021, nominal spending throughout the U.S. economy rose at an annual rate of 14.3 percent, pushing aggregate demand well above the pre-COVID-19 trend line. The rapid growth in spending helped push inflation well above the Fed’s 2 percent target.
So where did the Fed go wrong?
In 2020, the Fed adopted average-inflation targeting (AIT) to avoid the mistakes made during the 2010s, when an insufficiently expansionary Fed policy kept the money supply tight and allowed the economy to stagnate for years, with high unemployment making it especially difficult for younger workers to find jobs. To its credit, the Fed’s much more aggressive approach to the COVID recession did allow for a very fast recovery in the job market. Even with the recent high inflation, the economy is doing better than in the early 2010s.
Nonetheless, the Fed could have done even better. Like a general fighting the last war, it has traditionally pivoted too slowly when one problem is addressed and the opposite problem moves to the forefront. Under average-inflation targeting, a bit of overshooting during 2021 was appropriate after the 1.3 percent inflation of 2020. Unfortunately, inflation soared to 5.7 percent in 2021 and looks likely to be far too high again in 2022.
I see at least three reasons for the Fed’s policy mistake.
One was too much focus on closing the so-called “output gap” between actual real GDP and potential GDP, which is exceedingly difficult to estimate. Throughout 2021, employment remained depressed well below pre-COVID levels, suggestive of a weak economy that needed more stimulus. But the large estimated output gap was an illusion. In fact, COVID had sharply reduced labor force participation, leaving employers with increasing difficulty finding workers despite the below normal level of employment.
Because real output gaps are so difficult to estimate, the Fed should focus on variables such as nominal GDP (NGDP). By that criterion, it was clear by the second half of 2021 that policy was becoming too expansionary. An NGDP growth rate of roughly 4 percent is consistent with the Fed’s 2 percent inflation target. Recently, growth in NGDP has been far above that rate.
That brings us to the second reason for the Fed’s mistake. At a press conference last month, Fed Chair Jerome PowellJerome PowellBiden Fed picks get boost from dozens of economists A new role for central banks post COVID-19? Inflation: Where do we go from here? MORE was asked if the Fed should aim for less than 2 percent inflation after a period of excessively high inflation in order to bring the average back down to the long-term target. Powell forcefully rejected that suggestion, directly contradicting the Fed’s new AIT policy. If the term “average” is to have any meaning, there must be times when the Fed aims for above or below 2 percent inflation. Powell seemed unaware that aiming for below 2 percent inflation might be required.
Market participants pay close attention to Powell’s comments, and surging prices in late 2021 may have partly reflected a number of his public statements implying that the Fed would not “take away the punch bowl” before the economy overheated.
This does not mean the Fed is unaware of the inflation problem. Indeed, several Fed officials have acknowledged a need to tighten policy at some point in 2022. But why wait so long? Why set a target interest rate of zero and continue quantitative easing when the economy is booming and inflation is running near 6 percent?
The Fed’s sluggish response to economic overheating points to a third reason for its mistake: Officials were frightened by the market’s “taper tantrum” in 2013. As a result, they now prefer to signal policy changes very gradually. But the “tantrum” was not actually caused by an abrupt tightening in policy. Rather, markets reacted to an inappropriate tightening of policy when unemployment was still at 7.5 percent. In contrast, policy tightening today would be appropriate. The longer the Fed waits, the more painful it will be to bring inflation back down to target.
Fed officials seem to assume that financial markets want as predictable a path for interest rates as possible. What markets actually want is the assurance of a stable outcome for the economy. It does no good to hold interest rates at zero for an excessive period if that causes the broader economy to overheat.
To summarize, the Fed needs to target nominal variables such as inflation and NGDP, not difficult-to-estimate real variables such as output gaps. It also needs to focus on stable economic outcomes, not on stabilizing the interest rate. Finally, when it announces a new policy rule, such as average-inflation targeting, it needs to stick to it.
Scott Sumner is the Ralph G. Hawtrey Chair of Monetary Policy with the Mercatus Center at George Mason University and a professor emeritus at Bentley University.
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