Inflation is coming down, but the future of monetary policy remains uncertain. There’s widespread disagreement about central bankers’ next move. That includes some members of the Federal Open Market Committee, who wanted a rate hike in June.
Congress requires the Fed to pursue stable prices, full employment, and moderate long-term interest rates. The consensus among economists is that achieving the first is the best way to get the second and third. But we don’t know exactly what “stable prices” means. Congress has never defined it. Since at least 2012, the Fed has interpreted it to mean 2 percent inflation. They’re probably shooting for that in their planned tightening.
Economic theory can help us understand price stability. The macroeconomic component has to do with stabilizing the dollar’s purchasing power—its general exchange rate against goods and services. This is sometimes called creating a “nominal anchor.” The microeconomic component, which is just as important, is often overlooked.
Monetary policy should help the price system function as effectively as possible. Supply and demand ought to determine market prices, which reflect real resource scarcities across various lines of production. There’s no way central bankers can predictably improve on the market allocative process. What they can do instead is create the background conditions that make price signals reliable.
Money should facilitate exchange without impinging on the terms of exchange. Economists call this “monetary neutrality.” It prevails when the supply of money in the economy equals the demand to hold it at the going price level. An excess demand for money spills over into markets for real goods and services, lowering production and employment. The errors are sorted out by an increase in money’s price, which means a decline in the price level. Conversely, an excess supply of money makes production and exchange look more profitable than it really is. The errors are sorted out by a decrease in money’s price, which means an increase in the price level.
Both underproduction and overproduction are costly. Monetary policy-induced recessions are bad. Monetary policy-induced expansions are bad, too. The goal should be keeping the economy as sustainably productive as possbile.
If the central bank offsetts changes in money demand, it also tends to stabilize the purchasing power of the dollar. This corresponds well to conventional definitions of price stability.
But that doesn’t mean inflation never changes. The supply side of the economy, which captures total economic productivity, also matters. When we get better at turning inputs into outputs (say due to technological innovation), the purchasing power of the dollar should rise. Likewise, if a natural disaster (say a pandemic) temporarily throws a wrench in supply chains, the purchasing power of the dollar should fall. Importantly, central bankers cannot do anything to offset supply-side changes without causing additional economic turmoil. Remember: monetary policy should facilitate maximum sustainable production. When the supply side changes, what’s sustainable necessarily changes, too.
This way of thinking suggests a specific policy rule: nominal spending targeting. The nominal anchor is total spending in the economy at current prices. Monetary policymakers change the money supply to offset changes in money demand, helping markets reach their maximum potential. This naturally keeps the total spending stream steady.
Hence, price stability is compatible with supply-side price changes but not demand-side price changes. Ideally the Fed would permit the former and neutralize the latter. If it tried to fight back against, for example, a commodity price shock, the requisite monetary tightening would only bring inflation down at the cost of destroying wealth. A nominal spending target, which is the nominal-anchor rule consistent with monetary neutrality, is the best central bankers can do.
Congress is free to define “price stability” however it wishes. If it wants a strict inflation target in all circumstances, that’s its right. But legislators would be well-advised to pay close attention to the microeconomic foundations of monetary policy. There are good reasons for wanting the price system to communicate economy-wide signals about rising or falling productivity. Economics teaches us the best definition of stable prices is one that promotes overall economic coordination. That means amplifying the signal while filtering out the noise. Let the price system work!