August 12, 2022 Reading Time: 4 minutes

The Fed is in a difficult situation, partly of its own making. Inflation, depending on how you measure it, is running on the order of 5 to 10 percent per year.

The Federal Reserve’s preferred target for inflation – the personal consumption expenditures price index – increased at a 7.5 percent annual rate for the first half of 2022. Some other measures of inflation are even higher. 

At the same time, goods and services produced in the economy have fallen. Real Gross Domestic Product (real GDP) fell at a 1.3 percent annual rate in the first half of 2022.

It was not all that long ago, from 2012 to 2019, when inflation averaged 1.4 percent per year.  The growth rate of real GDP over the same period was 2.2 percent per year. This is prior to the COVID-19 pandemic, lockdowns, and extraordinarily large government stimulus payments.

Before the rapid recent increase in inflation, the Federal Reserve was attempting to increase inflation. The average of 1.4 percent per year from 2012 to 2019 was less than the Fed’s target of 2 percent over the same period. In an attempt to raise expected inflation, the Federal Reserve shifted from an inflation target of 2 percent to a flexible average inflation target of 2 percent. This was announced by Chairman Powell at the 2020 Jackson Hole conference. This average could easily be interpreted as reflecting an intention to have inflation above 2 percent for some time, given the average inflation of 1.4 percent from 2012 to 2019.

Due to COVID-19, the government made large stimulus payments to the public. These payments were largely financed by government debt, much of which was purchased by the Federal Reserve. The stimulus payments were a shower of money into people’s bank accounts which increased the amount of money in the economy. This additional money predictably resulted in higher subsequent inflation. These developments, not solely of the Federal Reserve’s doing, increased the inflation rate. No doubt this increase in inflation is quite a bit more than the Federal Reserve intended.

Can we reduce the likelihood of similar errors in the future?

There were conceptual errors, and there are no obvious structural changes that would help reduce these conceptual errors given the current discretion allowed to monetary policymakers. The Federal Reserve completely ignores the nominal quantity of money, best measured by M2, which was a serious mistake in this inflationary episode.

One way to reduce the likelihood of similar errors in the future is to make it harder to bring about similar errors. In this regard, a rule to constrain monetary policy could be helpful.

The Federal Reserve’s goal of average inflation of 2 percent per year can be interpreted as a rule of sorts. The Federal Reserve sets out a goal and the Federal Reserve attempts to hit it. This is a self-imposed constraint. An example from everyday life would be having a goal of saving 10 percent of every check for retirement. While some people are successful at doing this, many others find themselves buying shoes for their children with some of that 10 percent and being glad to be able to do it.

An alternative is an externally imposed constraint. Congress and the administration could pass one of a variety of laws that would impose constraints on the Federal Reserve’s behavior.

The Federal Reserve might be tempted to increase its target inflation rate, in the belief that increasing the target will temporarily increase employment and decrease unemployment. The increase in the target inflation rate is not hypothetical. It happened with the change to a flexible average inflation rate. In fact, some have been arguing for an increase to even 4 percent per year for some time.

The constraint I am suggesting is a constraint on the Federal Reserve’s goal.

Such a rule would not constrain the Federal Reserve’s interpretation of how to hit the target; it would constrain the target at which it is aiming.

Who would set the goal? There are alternatives with costs and benefits. A law passed by Congress and signed by the President could directly set the target, or the target could be determined periodically by the President and his staff in discussions with the Federal Reserve.

An inflation target is not the only possible target. An alternative target is nominal GDP, the dollar value of spending on final goods and services. A nominal GDP target would deliver roughly constant inflation, but would allow inflation to increase when real GDP falls due to adverse supply disturbances or lower technological change. An inflation target tends to amplify the effects of such supply or technology shocks; the central bank is required to reduce nominal spending in order to hit the inflation target.

For a target to be taken seriously, a range of inflation rates or nominal GDP growth rates is necessary. If the target is exactly 2.0 percent per year, the probability of hitting this target is zero. This means that deviations of inflation from the goal need not be taken seriously. Instead, with a range of 1 to 3 percent per year for example, inflation rates outside that range could be the subject of serious discussions.

If the government imposes an inflation or nominal GDP target, what happens if the Federal Reserve misses the target? It is possible that the Federal Reserve misses the target on purpose, independent of the goal set by the President and Congress. That has not been an issue in inflation-targeting countries in which other branches of government have a role in setting the inflation target. There is no reason to think that the Federal Reserve would ignore the legislative and executive branches of government. As a recent summary of inflation targeting in the first country to adopt it indicates, New Zealand’s inflation targeting has had  temporary deviations from the target, not persistent ones.

A side benefit of having the executive branch and Congress participate in determining the target inflation rate would be the involvement of elected representatives.

In sum, a target that is not determined solely by the Federal Reserve is less subject to changes solely due to deliberations at the Federal Reserve. It will enhance monetary policy’s effectiveness.

Gerald P. Dwyer


Gerald P. Dwyer is a Professor and BB&T Scholar at Clemson University. From 1997 to 2012, he served as Director of the Center for Financial Innovation and Stability and Vice President at the Federal Reserve Bank of Atlanta. Dwyer’s research has appeared in leading economics and finance journals, as well as publications by the Federal Reserve Banks of Atlanta and St. Louis. He serves on the editorial boards of the Journal of Financial Stability, Economic Inquiry, and Finance Research Letters. He is a past President and member of the Executive Committee of the Association of Private Enterprise Education. He is also a founding member of the Society for Nonlinear Dynamics and Econometrics, an organization for which he served as President and Treasurer.

Dwyer earned his Ph.D. in Economics at the University of Chicago, his M.A. in Economics at the University of Tennessee, and his B.B.A. in Business, Government, and Society at the University of Washington.

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