– September 8, 2020

At the end of last month, Federal Reserve chairman Jerome Powell announced a shift in one of its decades-long policy goals. It’s a move that should worry investors and workers alike. Here’s what happened and why it’s a problem:

At the Fed’s annual Jackson Hole symposium, Powell said that instead of targeting an annualized inflation rate of 2%, the institution would allow the rise in the cost of living to go above that rate for long periods. The idea, Powell explained, was to take account of long periods when inflation had remained stubbornly below its target.

“The persistent undershoot of inflation from our 2 percent longer-run objective is a cause for concern,” Powell said. “[…] inflation that is persistently too low can pose serious risks to the economy.”

The marked policy change is bad news on so many levels. But let’s start with the basics.

Record of Failure

It’s hard to see the Fed achieving higher inflation, given its recent failure in this matter. A quick look at the monthly consumer price index data over the last decade shows that for the vast majority of the period, inflation was well below 2%. Or put another way, despite all the money printing by the Fed and extended periods of low interest rates, the Fed hasn’t hit its targets in any sustainable way.

“I don’t believe there is any way the Fed can control the inflation rate,” says David Ranson, director of research at financial analytics firm HCWE & Co. “That is part of the general conceit that the Fed can’t afford to admit.” 

In other words, the Fed should know it is powerless in this regard, and failure to admit that is part of what Ranson calls its desire for the institution to have a “grandiose role.”

Fed Can’t Get Out of its Own Way

Another part of the problem is that the Fed has taken actions that stop inflation from rising, says Victor Sperandeo, CEO of EAM Partners LP, a financial firm in Dallas. The central problem is that the Fed pays commercial banks interest income on their excess cash reserves held at the central bank. “If you really wanted inflation, end paying interest on excess reserves,” he says.

The reasoning is simple. Banks have no incentive to make business loans when they can earn risk-free income by holding their excess cash at the Fed. Business loans are key for economic growth and tend to be larger than consumer loans.

If the interest was eliminated on excess reserves, then the broad banking sector would have an incentive to make loans. In turn, the increase in loans would increase the velocity of money, a key metric that measures how fast money moves around the economy. 

Currently, the velocity of the M2 measure of money is at its lowest level going all the way back to 1959, according to data from the St. Louis Federal Reserve. M2 is a narrow gauge of money which includes bills and coins, as well as demand deposits and other near-money such as money-market securities and savings.

The low velocity of M2 means money is moving around the economy very slowly, which isn’t conducive to making prices rise even when there is lots of money being created by the Fed. “Any student of history knows that it is the velocity of money that causes inflation, not quantity,” Sperandeo says. “They’ve been letting velocity decline for years.”

The decline in the velocity of money has been fairly steady since the mid-1990s. That drop morphed into collapse as a result of the Covid-related and government-imposed lockdowns. People working from home just stopped spending and instead hoarded their cash.

Unlegislated Tax Increase?

One way to describe inflation is a reduction in the purchasing power of money. The money you’d need to buy a full-sized car 10 ten years ago probably won’t be enough to get a similar one now.

By wanting to increase the rate of inflation higher than its longstanding target the Fed is saying it wants to reduce the value of your earnings and your savings. In effect, it would be like an increase in taxes getting made by unelected officials. “It is an unlegislated tax increase,” Sperandeo says. 

While the government does have the power to change tax rates, in the U.S. these decisions are made by elected representatives at a Federal, State, and local level. The similar is true in most democracies. It is certainly not normal for unelected officials to institute tax hikes arbitrarily. In any event, as mentioned above, the Fed is unlikely to achieve its goal anyway.

The Fed’s Goal is Now Nebulous

A month ago, business leaders knew that the Fed had a fixed target of 2% inflation. Now they know that the target is moveable. What isn’t known is how high the Fed will let inflation rise before containing it. In short, the Fed has given itself a nebulous goal. 

That raises an extra unknown at a time when the economy is rife with uncertainty. Already business leaders and investors are dealing with a Covid-related patchwork quilt of rules surrounding working and traveling. In addition, there is a forthcoming presidential election in which the two candidates offer starkly different policies. Now the Fed has added in an extra layer of uncertainty for executives to tackle. As most students of economics know, more economic policy uncertainty leads to lower economic growth than would otherwise be the case.

The Fed Isn’t the Right Institution

If the U.S. government really thought that higher inflation was desirable, then the institution most likely to make a difference would be the U.S. Treasury, not the Fed, says Ranson. 

Or put simply, if the U.S. government wanted more inflation, then the President could instruct the Treasury to push down the value of the dollar. That would immediately make all commodities and imports more expensive. Quickly, those costs would get passed onto consumers. 

“Inflation comes from the strength or weakness of the dollar and the Fed has no practical means of controlling the value of the dollar,” he says. “That has always been a policy that is within the purview of the Treasury.”

Simon Constable

Simon Constable

Simon Constable is a fellow at the Johns Hopkins Institute for Applied Economics, Global Health and the Study of Business Enterprise. His first book, “The WSJ Guide to the 50 Economic Indicators That Really Matter, which he co-authored with Robert E. Wright, was an economics category winner in the 2012 Small Business Book Awards at Small Business Trends. You’ll find his work in The Wall Street Journal, Barron’s, Forbes, MarketWatch.com, TheStreet.com, the New York Post, the New York Sun, and the South China Morning Post. Constable holds an MBA from the Darden School of Business at the University of Virginia.

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