The Federal Reserve balance sheet contains roughly $2.5 trillion worth of Treasuries, Fannie Mae bonds and mortgage-backed securities. But there is one asset the Fed considers invaluable. Credibility.
Most people think the central bank’s job is manipulating interest rates, but the Fed is really in the business of making and keeping promises about the economy. But lately the Fed is obsessed with a narrow construction of credibility that is holding back the entire country.
The Fed has fetishized two-percent inflation.
The Fed makes a very simple promise: It promises to keep inflation at a certain level every year. That level has changed over the past 30 years, but it’s currently around 2% a year. If the economy is running too hot, the Fed raises interest rates. If it’s running cold, it lowers rates.
For 30 years, this worked spectacularly. Recessions were rare and shallow. Inflation was low. Then 2008 happened. Even zero interest rates weren’t enough to revive the collapsing economy. That’s still mostly true now. In fact, our disappointing recovery is in large part the result of a central bank target that no longer serves the economy.
Let’s think about why a two-percent inflation target is a problem now, and what a better target would look like. The above chart compares the economy’s long-term growth trend (blue) with the actual size of the economy (red). I’ve included the numbers going back to 1980 so that you can see that this isn’t a case of the housing bubble making us vastly overestimate the economy’s productive capacity. You can go back further if you like. The results are the same. The two lines barely deviate from each other — until now. (The only other exception is the Great Depression).
We have a lot of catching up to do. But a two-percent inflation target — mostly — prevents us from getting the catch-up growth we need.
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