The Federal Reserve System’s Board of Governors summarizes Section 2A of the Federal Reserve Act of 1913, which authorized the central bank’s creation, as requiring it “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Channeling Nobel Laureate Milton Friedman, I say in the classroom that the Fed is supposed to pursue the “Holy Trinity” of price stability, full employment, and economic growth.
“Full employment” was added to the Fed’s remit by the Employment Act of 1946 because policymakers thought that the American economy would struggle to find jobs for the millions of soldiers and sailors returning to civilian life at the end of the Second World War. That fear was falsified by the robust growth that followed peacetime reductions in public spending and the reinvigoration of private enterprise. Nevertheless, an amendment to the 1946 law passed in 1978—the Full Employment and Balanced Growth Act, often called “Humphrey-Hawkins” after its two co-sponsors—reinforced the Fed’s triple responsibility for prices, employment, and growth.
According to the Fed itself, Humphrey-Hawkins sought the fulfillment of multiple objectives: “Among them,” adding my own emphasis, “unemployment should not exceed 3 percent for people 20 years or older, and inflation should be reduced to 3 percent or less, provided that its reduction would not interfere with the employment goal. And by 1988, the inflation rate should be zero, again provided that pursuing this goal would not interfere with the employment goal.”
The challenge for the Fed is that it wields only one policy tool—the growth rate of the money supply—to hit its three moving targets. That’s impossible. The Fed’s record of monetary policymaking success, past and present, is, as many academic analysts conclude, “mixed.” Nowadays, especially considering the 40-year high inflation rate (nine percent) of recent memory, mortgage rates north of seven percent, and low post-pandemic unemployment, focus has shifted almost exclusively to the Fed’s goal of promoting price stability.
The Fed’s current target is an increase in the general level of prices of two percent per year. It was adopted in the late 2010s when monetary policymakers were “struggling to bring inflation up to that level” (Joseph C. Sternberg, “The Fed’s Pro-Inflation Critics are Off-Target,” Wall Street Journal, August 25, 2023, p. A15; my emphasis). The current mantra of some economic gurus is that the central bank’s target ought to be closer to the three percent annual rate at which prices have been rising in the past few months.
Why two percent, three percent, or any other arbitrary inflation number? Why not zero, as memorialized nearly fifty years ago in Humphrey-Hawkins? One reason is that some economists—not including me—think that a little inflation is a good thing. According to the Fed, an inflation rate of two percent “is most consistent with” satisfying its mandate to maintain full employment.
More pragmatically, a two-percent annual rise in the general level of prices (and the rate of interest associated with that inflation rate, which in theory is four percent, computed as the sum of the expected rate of inflation and the two-percent real rate of return on invested capital that has prevailed almost forever), gives the Fed policymaking room for lowering interest rates to stimulate the economy during downturns. But the need for such a cushion merely is an assertion, not backed by any theory or evidence that the Fed has advanced, nor does it recognize the very real costs of inflation. (Among them, prices become more volatile around the average inflation rate as the average rises.) More to the point, the four rounds of “quantitative easing” conducted since 2008 indicate that countercyclical monetary policy is not constrained if interest rates are close to or at a zero lower bound.
The Fed obviously would have more flexibility if its annual inflation target were five percent rather than two percent. But policymaking discretion is cold comfort for ordinary Americans in their roles as consumers, producers, or employees. The hoary “Rule of 72” says that with an inflation rate of two percent, prices will double in thirty-six years (= 72/2); prices double in twenty-four years (72/3) if inflation averages three percent per year; and in not quite fourteen and a half years (= 72/5) with an inflation rate of five percent. Prices would have doubled in just eight years if July 2022’s inflation rate of nine percent had persisted.
The conventional wisdom is that the Fed “sets” market interest rates. That conclusion may be accurate for the Federal Funds Rate, the rate of interest charged on overnight interbank loans, which the Fed controls directly. It also controls the interest rate paid on member banks’ excess reserves deposited in accounts at the Fed itself.
In general, however, interest rates are determined in financial markets comprising hundreds of millions of prospective borrowers and the smaller number of institutions or private parties from whom they seek loanable funds. As such, “major changes in interest rates are usually caused by changes [in] how the public wants to hold its net worth,” whether in the forms of cash, savings, certificates of deposit, money market accounts, real estate, or other investment vehicles.
Market-determined interest rates equate the demand for credit with its supply. And if market forces are the main driver of changes in market interest rates, the Fed is forced to follow the market up or down rather than lead it toward policymakers’ “preferred” rate.
The Fed has struggled to hit its two-percent inflation target in recent periods, especially during the Covid pandemic when nominal interest rates were close to zero. It now aims to engineer inflation rates above the current target so that inflation averages two percent over a longer time horizon. Hence, the calls from some quarters to raise the target to three percent.
It is not clear, however, that three percent inflation is any more achievable than a two-percent target has been. The economy’s growth rate is anemic. Putting production and jobs onto his policy back burner, Fed Chairman Jerome Powell, who explicitly rejects raising the targeted inflation rate, opines that an economy expanding faster than a projected two percent per year “could put further progress on inflation at risk and could warrant further tightening of monetary policy” (Nick Timiraos, “Powell Says Fed to Move Carefully on Rates,” Wall Street Journal, August 26–27, 2003, p. A1).
Discussions of monetary policy become Alice-in-Wonderland-ish. Those discussions are characterized by policymakers’ fatal conceit (or hubris) that inflation, employment, and interest rates can be micromanaged in ways that do less harm than good. The history of the Federal Reserve System points to the opposite conclusion. It’s well past time to recognize that the monetary emperor has no clothes.
This article was published at The Beacon