The U.S. Federal Reserve has all but exhausted its most powerful weapon: the ability to lower short-term interest rates. If it wants ammo to fight the next economic slump, it will have to give up its obsession with ultralow inflation.
Once, not so long ago, Americans thought their central bank near omnipotent. As economist Paul Krugman put it in 1997, the U.S. unemployment rate would be what then Fed Chairman Alan Greenspan wanted it to be, “plus or minus a random error reflecting that he is not quite God.” With the Fed’s short-term interest-rate target at 5.5 percent, the central bank had plenty of room to cut rates if it wanted to boost markets and stimulate the economy. It did just that when financial troubles struck in 1998, keeping the boom roaring for two more years.
Today, no such intervention is possible. The Fed quickly slashed its interest-rate target to near zero during the crisis of late 2008. Since then, it has been pinned against what economists ominously call the “zero lower bound,” forced to confront the most challenging economic period since the Depression without its monetary tool of choice.
The policy paralysis might look like a stroke of bad luck stemming from a once-in-a-century downturn. In fact, the groundwork for the zero-rate crisis was laid in the early 1980s, when then Fed Chairman Paul Volcker proved that a determined central bank could whip runaway inflation by raising interest rates. Inflation has been on a steady path downward ever since, toward the 2 percent figure central bankers seem to judge as the highest prudent rate.
The steady disinflation -- a welcome development in many ways -- had a side effect: the corresponding compression of market interest rates. With the inflation of the 1970s gone, lenders didn’t need to charge high rates to compensate for the fact that the money they got back couldn’t buy nearly as much as the money they lent. The interest-rate target needed to keep inflation in check also declined, from as high as 20 percent in the Volcker era to less than 7 percent in the 2000s.
On the flip side, the Fed had to bring interest rates lower to combat economic slumps. The Fed’s target rate, which had never dropped below 5.75 percent in the 1980s, sank below 3 percent in the 1990s and hit 1 percent during the “jobless recovery” of the early 2000s. By squeezing inflation, the Fed was venturing closer to the dread zero lower bound. When the 2008 recession struck, Fed Chairman Ben S. Bernanke had less room to respond to the downturn than any chairman in half a century.
Monetary policy isn’t entirely powerless at the zero lower bound. Since late 2008, the Fed has purchased trillions of dollars in Treasury and mortgage securities to cut borrowing costs and raise asset prices. It is also aiming to boost growth by promising to keep its interest rate low until the recovery is well-established. In December it set precise guidelines -- an unemployment rate of 6.5 percent and short-run inflation expectations of about 2.5 percent -- to help markets understand when rates might eventually rise. These nontraditional moves greatly reduced the odds of damaging deflation and nudged economic growth and employment higher than they otherwise would have been.
Still, the Fed has done less than it would have liked due to its mistrust of such unconventional policies. The economist Jeremy Stein, a member of the Fed Board of Governors, laid out the potential risks in a speech last October. “The bar for the use of nontraditional policies is higher than for traditional policies,” Stein said. “If the federal funds rate were at 3 percent, we would have, in my view, an open-and-shut case for reducing it.”
That’s a worrying prospect. For a generation, the Fed has been the economy’s great stabilizing force, largely succeeding in keeping unemployment as low as is consistent with dormant inflation. If the Fed lacks the confidence it once had, then Americans must either get used to deeper recessions and slower recoveries or count on fiscal policy -- higher levels of government spending and lower tax rates -- to take over much of the job of recession-fighting. Given the government’s heavy debt burden and gridlock in Washington, neither option seems particularly attractive.
So how can the Fed get its mojo back? It might seem wise to raise rates sooner rather than later. Problem is, with the economy still running below its potential, higher rates would choke off recovery and worsen unemployment -- much as they did in Japan when that country’s central bank sought to get up off the zero bound in 2006. The Fed’s commitment to hold rates down as long as inflation behaves demonstrates its commitment to avoid a repeat of Japan’s mistake.
A better option would be for the Fed to rethink how much inflation it’s willing to accept. Allowing a bit more would bring down the “real,” or inflation-adjusted, interest rate -- a change that has the same stimulating effect as a lower target rate. An economy growing fast enough to generate rising inflation would be prepared for the moderating impact of rate increases sooner, ideally well before the next recession strikes. Perhaps most important, by accepting a period of inflation comfortably above the miserly 2 percent level, the Fed would create room for rates to top out at a level that provides more of a safety cushion above the zero lower bound. When the next recession struck, it would be prepared.
A burst of inflation isn’t without potential costs. Those who remember the 1970s and 1980s may worry that prices will spiral ever upward, sapping consumer purchasing power, eroding savings and contributing to economic stagnation. But these threats should be manageable if the Fed keeps inflation expectations under control by providing precise communication about its policy goals. It could change its official inflation target to, say, 3 percent or 4 percent. Or it could shift to a new goal altogether, such as stable growth in the cash value of national income -- an approach known as nominal gross domestic product targeting. This would allow for more flexibility while reassuring the public that policy wouldn’t run out of control.
The Fed is already moving in the right direction. Its current approach to raising interest rates -- promising to maintain stimulus until unemployment and inflation hit pre-defined thresholds -- is designed to give it the flexibility to accept above-target inflation for a short period while maintaining longer-run inflation expectations at 2 percent.
But time is running out. Over the past 150 years, the average economic expansion has lasted just 42 months, a milestone the current recovery has already passed. If the Fed doesn’t want to face the next recession with an empty quiver, it must accept that there are worse things in life than moderate inflation.
(Ryan Avent is economics correspondent at The Economist. The opinions expressed are his own.)
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