The Fed Should Stop Targeting Prices

For the first time in more than three years, the Federal Reserve has raised its interest rate target, a move that it has been telegraphing since late 2021. Despite the advanced warning, the announcement was preceded by the usual debates over whether (and how much) the Fed should “raise interest rates.”

That debate is largely a distraction.

While everyone was busy arguing about how aggressively the Fed’s Open Market Committee should act, short-term interest rates were busy forcing the committee’s hand. The 3-month Treasury was 0.05 percent in November but ended February at 0.33 percent. From February 1 to March 15, the rate on overnight nonfinancial commercial paper basically doubled, rising from 0.16 percent to 0.33 percent. The one-week financial commercial paper rate followed nearly the same path.

What the Fed actually does is more complicated than what most news stories imply, partly because the Fed does not simply “control” our economy’s “interest rates.” It does, however, try to tighten or relax credit conditions based on its macroeconomic goals. Those goals, of course, come from the Fed’s congressional mandate, one part of which requires the Fed to “promote” price stability.

So, the fact that the rate of inflation has continued to accelerate and break multi-decade records for the past several months has also forced the Fed’s hand. That is, the inflation trend all but ensured that the Fed would soon raise its target rates. Still, the Fed’s congressional mandate is where the debate gets interesting.

The mandate is usually called the dual mandate because it requires the Fed to promote both stable prices and maximum employment. (Technically it refers to more than two variables.) However, the mandate is unclear and leaves the Fed with so much discretion that there really is no easy way for Congress to hold the Fed accountable.

The Fed currently equates price stability with inflation that averages two percent over time, but it won’t say how it calculates that average. Is it two percent over the previous six months? The previous twelve? Is it two percent over some future period? The answer, under the Fed’s “flexible form of average inflation targeting,” is “yes, if we say so.”

The mandate leaves the Fed even more leeway to interpret its employment goals, but the very fact that employment is in the mandate is more problematic. Most economists would agree with Fed Chair Powell that “the level of employment is determined mainly by non-monetary factors that are outside the Fed’s control.” (This view is far from a fringe opinion, and it is regularly publicized by other central banks.)

Regardless, many economists have argued for some kind of policy rule to hold the Fed accountable for what it’s supposed to achieve. Others (including the Fed) have pushed back on such efforts as being too restrictive and tying the Fed’s hands. There are too many unknowns, they say, so the Fed has to remain flexible.

But there is a policy option that would avoid having to deal with so many unknowns. And it could be implemented with a policy rule. Congress could replace the existing mandate with one that requires the Fed to maintain a reasonable growth path of overall nominal spending in the economy.

Many people will recognize this mandate as one that requires the Fed to target nominal gross domestic product (NGDP). NGDP targeting has many advantages. It avoids, for instance, forcing the Fed to forecast potential GDP. It also relieves the Fed of having to estimate what full employment might be, requiring, instead, that the Fed foster the monetary conditions that tend to favor full employment.

An NGDP targeting rule would also allow the Fed to deal with inflation, but to do so in a much smarter way. That is, it would allow the Fed to respond to inflation caused by too much growth in spending while also standing pat on inflation caused by shocks to aggregate supply.

This advantage would come in handy right now.

Monetary policy cannot reverse the damage done by negative supply shocks, such as a war or government shut-downs due to a pandemic. These shocks limit the amount of goods in the economy, causing prices to rise. If the Fed tightens to prevent that inflation, it leaves people without the overly scarce goods and services, and even less money to obtain what is available.

The current inflation is being driven by both supply shocks and rising demand, and it is very difficult to parse out how much inflation is due to either one (in real time, at least). The good news, though, is that targeting total nominal spending gets around this problem.

All the Fed has to do is adjust its policy stance so that there is enough money in the economy to maintain the targeted level of nominal spending.

Many fans of free markets say that NGDP targeting amounts to central planning. What they miss, though, is that NGDP targeting does not require the Fed to target the real level of goods and services in the economy. That is, the goal is not to target the number of computers, cars, smartphones, etc. that people produce.

Instead, the goal is to target the nominal value that we attach to those things. Importantly, the goal is to target that nominal value while letting prices adjust – up or down, even if that results in inflation falling below zero – so that monetary policy distorts the economy as little as possible. (Monetary policy would be neutral.)

Another advantage of NGDP targeting is that it would let prices fall when productivity increases, thus allowing people to better reap the gains of a growing economy. A constantly increasing price level is not, in fact, a precondition for a growing economy.

A quick tally shows that NGDP targeting avoids several policy unknowns, thus making it easier to implement effective monetary policy. NGDP targeting also avoids improper policy responses to both negative and positive supply shocks. And it avoids asking the Fed to target variables that it cannot control or objectively define, such as maximum employment or potential GDP. It would result in a more passive central bank, one that can do much less to distort the economy through monetary policy.

Members of Congress owe their constituents to ask Fed Chair Powell about the advantages to NGDP targeting. That kind of dialogue would be infinitely more valuable than arguing over whether the Fed should raise its target rate a quarter point for the next two consecutive months or the next three.