The consumer price index rose by only 3 percent during the past 12 months. President Biden is taking a victory lap, saying inflation has dropped for 12 months straight. That interpretation is debatable, given the variety of ways inflation is measured. Prices rose more in June than they had in May.
But there’s a clear enough downward trend that the Federal Reserve is already hearing calls to declare its own victory over inflation, rather than continue to raise interest rates until it achieves its stated goal of bringing the inflation rate down to 2 percent. Although the case for relenting is not frivolous, the Fed should stay the course.
Even before the government released the latest inflation number, Mark Zandi, the chief economist at Moody’s Analytics, asked, “Do we want to sacrifice the economy to the altar of the 2% inflation rate?” He suggested that a 3 percent inflation rate might be tolerable.
We should give Zandi props for bringing to mind the closing line of William Jennings Bryan’s 1896 protest against tight monetary policy: “You shall not crucify mankind upon a cross of gold.” But Zandi’s argument has more than rhetorical resonance going for it. The 2 percent goal is arbitrary. A stray remark by a New Zealand official is generally thought to have begun the chain of events that led to the goal becoming orthodoxy for central banks around the world.
Zandi is right that relatively steady, predictable and low inflation matters more than the exact target rate. A steady 3 percent inflation rate would even have some advantages over a lower one, such as raising nominal interest rates and thus giving central banks more room to maneuver.
That’s why 22 prominent economists wrote a letter to the Fed in 2017 urging it to consider a higher inflation target. And if we were designing a monetary policy from scratch, we might well pick a 3 percent target. But we’re not. There’s a history we have to consider.
The Federal Reserve let inflation run out of control from the late 1960s through the early 1980s, and then painfully wrung that inflation out of the economy through interest-rate hikes that led to double-digit unemployment. It drove inflation lower and eventually settled on the 2 percent goal, which was formally adopted in 2012 but has arguably been in place since 1995.
The current inflationary episode is the most serious one we have endured since the recession of the early 1980s. The Fed was late to respond to it but has done so notwithstanding political pressure. Sen. Elizabeth Warren (D-Mass.) said last year that Federal Reserve Chair Jerome H. Powell was trying to engineer a “brutal” recession.
So far there is little evidence of brutality. The unemployment rate is 3.6 percent, lower than it was at any point from the presidency of Gerald Ford through that of Barack Obama and exactly where it was when the Fed started raising interest rates last year. The labor force participation rate among Americans in their prime working years has increased during this tightening cycle, making the low unemployment rate, which counts everyone who is actively looking for work, even more impressive.
Tightening has led to far less economic damage than its critics, or even some of its supporters, predicted. For Powell and his colleagues to abandon the 2 percent goal now would be to signal that they will flinch even in the absence of pain. If they should err again, as they did in 2021 and 2022, and inflation again rises, they will then have placed themselves in a terrible position.
Let’s say inflation hits 5 percent. How much credibility would the Fed have in pledging to do what it takes to hit its new 3 percent goal? Speculation that it would settle for 4 would be widespread. To convince markets that the Fed really means what it says would then require extra tightening. The Fed would be left with the same painful choice it faced in the late 1970s: Let inflation keep drifting higher, or stop it through, well, a brutal recession.
The pressure on the Fed is going to increase. But it should stick with the 2 percent goal. Its job isn’t done.