“Having a little inflation is like being a little pregnant.” — Leon Henderson, FDR Administration
This past summer, Sen. Elizabeth Warren (D-Mass.) berated Larry Summers and other interest rate hawks for possibly causing a recession with their calls for higher rates. She called Summers “someone who has never worried about where his next paycheck will come from.” While that’s probably true, Warren outed herself as one of several progressives who are willing to accept higher inflation if it means low unemployment.
This seems to be a growing and preferred trend among progressives: they'll sacrifice the Federal Reserve’s congressional mandate to maintain stable prices in order to prioritize the Fed’s other mandate to maintain “full employment.” For example, Jason Furman, who headed Barack Obama’s Council of Economic Advisors, recently retweeted a graduate student’s thesis calling for a Fed target rate of inflation between 2 percent and 3.5 percent after citing the supply shock as a major contributor to inflation.
Furman adds, helpfully, that the higher target rate would “add the decline in the neutral rate.” It surely would because the higher target rate of inflation would allow less Fed tightening. And the Wall Street donor class would surely love that because the lower “neutral rate”—the rate that neither stimulates nor constricts—allows equities to continue their upward trajectory because money will remain readily available. (Among the owners of assets, inflation matters far less than to wage earners because the value of assets increases along with inflation. Wages and savings typically do not.)
Funny how that kind of “economics” works, huh?
Why a ‘Target Rate’ of Inflation Anyway?
The Fed has used a 2 percent target rate for quite some time; at least since 1996. Ben Bernanke, then the Fed chair, made it explicit policy in 2012. It has been questioned previously.
The target exists for two reasons:
First, it is a buffer to prevent deflation and what is known as a “liquidity trap,“ a theoretical construct by which interest rates in a recession are at—or near—near zero so that people hold on to cash. Monetary policy is useless because rates are what economists call the ”zero bound.“ Rates can’t be lowered further to stimulate the economy. Prices also tend to fall in a liquidity trap, and to continue to spiral downward, as deflationary expectations set in. (”If it’s $10 this week, it will be $7 next week and $3 the week after, and so on and so forth.") Theoretically, the economy effectively seizes up as producers stop producing.
The second reason is that the 2 percent target allows for the Fed to cut rates to stimulate the economy, where a nil interest rate would leave it ineffective.
While the 2 percent target has those benefits, it has a downside. The value of savings is roughly halved over 36 years, so the value of money saved early in one’s career is considerably less in retirement years.
It’s Time to Marry Fiscal Policy to Monetary Policy
While supply chains were, indeed, interrupted during the pandemic and only came online in mid-2022, a good part of the inflation we experience now is attributable to the enormous increase in the money supply as a consequence of the pandemic and the lingering effect of the 2008 financial crisis. After the Trump administration, the Biden administration raised the money supply by an incredible 14 percent because of its spendthrift fiscal policy, as I explained here. While the money supply has tightened, somewhat, under the Fed’s efforts at quantitative tightening (QT), that is a long, slow road. And as the Fed takes this long, slow road, the U.S. economy will be just maudlin, not unlike the period after the 2008 Lehman Brothers bankruptcy.
To seize the initiative on inflation, the Fed’s QT needs to be married with tighter fiscal policy, to ensure that the Fed can draw down its balance sheet more rapidly than it currently has planned. While QT will “soak up” more excess cash, fiscal tightening will reduce the amount of cash that needs to be in the economy to finance deficit spending. It will also reduce liquidity and leverage in the capital markets to “spread the pain” of a slowing economy—an inevitable step to restrain the inflation of an over-heated economy—among the holders of assets as well as wage earners.
A Road to Economic Perdition
Were the Fed to alter its target rate of inflation, to increase it by up to another 1.5 percent, it would be but a first step to creating the kind of inflation Germans saw in the Weimar Republic. A 3.5 percent target rate of inflation would halve the value of savings in just 20 years, not 36, as with the current 2 percent target rate.
Moreover, if the Fed were to prioritize full employment over inflation, there would be nothing to prevent a revision of the target rate to, say, 6 percent or more if another burst of inflation struck the economy after adopting a 3.5 percent target rate. That would halve the value of savings in just 12 years. And there would be nothing to constrain raising the target rate even beyond that.
Countercyclical monetary and fiscal policy, which is almost always used to avert a recession, inevitably causes future economic fallout. Jim Grant, the publisher of Grant’s Interest Rate Observer, observed in his book, “The Forgotten Depression: 1921: The Crash That Cured Itself,” that then-President Warren Harding, Congress, and the Fed all basically adopted a laissez-faire attitude toward the post-World War I Depression and that the economy, basically, recovered itself. Congress slashed spending and the Fed raised its discount rate to a record 7 percent. (See a summary of the policies here.)
It is both sad and unfortunate that some workers and business owners will be adversely affected by this Fed-induced recession. But it is not unlike the diet one must undertake after over-indulging on Thanksgiving.
For the Fed, the Congress, and diners this Thursday, the better choice might be to not over-indulge in the first place.
