What Should the Fed Target?

Over the past 30 years a consensus has formed among central bankers around the notion that their job is to keep the rate of inflation at or perhaps just under 2 percent a year. Exactly how they arrived at this figure is not exactly clear to me; I think the idea is that you want inflation to be so low that people aren’t very conscious of it in their everyday lives, but you don’t actually want to bring it down to zero, because if you did, you might inadvertently fall into a deflationary downward spiral. So about 2 percent inflation provides a bit of protective cushion against drifting into that deflationary danger zone without raising inflation enough to become imbedded in the public consciousness.

Of course there are many different ways to measure inflation, and it was long ago understood by economists that no single price index could perfectly measure what we mean when we talk about the purchasing power of money. The most popular inflation measure is the consumer price index, but the CPI tracks only a subset of goods, those entering into the budget of a typical urban working household. In addition, there are all kinds of issues associated with adjusting for quality changes (generally improvement) in the goods consumed over time and issues associated with taking into account the changing composition of the basket of goods the typical urban household purchases (in part in response to relative price changes among the goods in the basket).

In recent years, the Fed has been placing greater emphasis on what is called “core inflation” than on the standard CPI, also referred to as “headline inflation.” Core inflation subtracts off from the CPI volatile energy and food prices, which, it is argued, are a) highly volatile, so that a given monthly change may present a misleading impression about inflation over a longer time horizon, and b) subject to various forces capable of producing significant price movements even with no change in monetary conditions. This reasoning suggests that by cross checking “headline inflation” with “core inflation,” the monetary authorities can reach a better judgment about the danger that inflation might accelerate than by looking at “headline inflation” in isolation.

Interestingly, the FOMC, in 2008, did just the opposite — with disastrous results. Even though core inflation was fairly well contained in 2008, the Fed viewed with alarm the increases in headline inflation associated with the run up in oil prices in the first half of 2008. Fearing that high headline inflation would cause inflation expectations to become unanchored, the FOMC refused to cut the Fed Funds rate below 3 percent from March to October — yes October! — 2008 despite all the evidence that the economy, even before the Lehman debacle, was already in, or about to fall into, a recession.

Once again, voices at the Fed and in the FOMC are being raised to focus attention on headline rather than core inflation. James Bullard, President of the St. Louis Fed, recently (5/18/2011) gave a speech to the Money Marketeers of New York University, dispassionately titled “Measuring Inflation: The Core Is Rotten.” The speech does not address directly whether current Fed policy is too tight or too loose, but Bullard, who supported QE2, providing crucial support to Bernanke in September 2010 after Bernanke’s Jackson Hole speech, signalling his intention to press forward with another round of quantitative easing, has since signaled his own opposition to further steps toward monetary ease. What Bullard does do is review a lengthy list of reasons why the Fed should stay focused on headline rather than core inflation. I have no reason to think that Bullard is not sincere in preferring that the Fed target headline rather than core inflation, but the subtext of Bullard’s remarks suggests to me that he believes that the current rate of headline inflation is higher than he would like it to be and that monetary policy should be adjusted accordingly.

The US focus on core inflation tends to damage Fed credibility. As I noted in the introduction, many other central banks have solidified their position on this question by adopting explicit, numerical inflation targets in terms of headline inflation, thus keeping faith with their citizens that they will work to keep headline inflation low and stable. The Fed should do the same.

But why should headline inflation be the measure of inflation of most concern to the Fed? Rather than explain, Bullard simply asserts that stabilizing headline inflation is what gives the Fed credibility.

With trips to the gas station and the grocery store being some of the most frequent shopping experiences for many Americans, it is hardly helpful for Fed credibility to appear to exclude all those prices from consideration in the formation of monetary policy.

Historically, the rationale for stabilizing a price index has been that, by doing so, the monetary authority could damp down the business cycle. This was the position of the great Swedish economist Knut Wicksell in the late nineteenth and early twentieth centuries. He believed that swings of inflation and deflation were the cause of the business cycle in output and employment. Stabilize prices in general and you would stabilize the rest of the economy. The great American economist Irving Fisher reached the same conclusion, characterizing the business cycle as a dance of the dollar.

It was in this spirit that the Federal Reserve Act imposed a dual mandate on the Fed to achieve stable prices while also promoting maximum employment. Does that dual mandate have any operational meaning? I think it does. It means, for starters, that you should not try to reduce inflation when it is already at a historically low level and when reducing it further threatens to decrease, not increase, employment. That’s all well and good, but how is one to know whether inflation is at historically low levels? Hasn’t headline CPI inflation has in fact been increasing over the past six months, rising by 3.3%.

I suggest looking at wages. According to the Employment Cost Index published by the St. Louis Fed, wages between the first quarter of 2001 and the first quarter of 2008 increased at any annual rate of 2.94%. In only two of those 29 quarters did wages increase at a less than 2% annual rate. Since the second quarter of 2008, wages have increased at a rate of 1.51%, and for the last 10 quarters in a row wages have increased at a less than 2% annual rate. So, despite the recent uptick in headline inflation, there is no sign that wage inflation is increasing. With wages increasing now half as fast as the trend from 2001 to 2008, with the labor market clearly not tightening and unlikely to do so in the foreseeable future, what possible justification can there be, under the dual mandate, or under any reasonable assessment of the risk that inflation will speed up, for monetary policy to aim at reducing inflation? No increase in the trend rate of inflation is possible without a roughly corresponding increase in wages. If wage inflation is virtually absent, there is negligible risk of an increase in the trend rate of inflation.

Throughout his long career, Ralph Hawtrey recommended stabilizing the wage level as the goal of monetary policy. Hawtrey did not advocate stabilizing a wage index, he advocated stabilizing the wage for unskilled labor. I am guessing that wages for skilled labor generally rise somewhat faster than the wages of unskilled labor, so we are very close to meeting Hawtrey’s criterion for wage stability. But the middle of the deepest downturn in 80 years is not the time to pursue the long-term goal of wage stability. If prices are now rising somewhat faster than wages, it is probably because of recent supply shocks that raised oil prices. Until wages start rising faster than the 3 percent rate at which they rose from 2001 to 2008, those supply side factors will not translate into a sustained increase in price inflation. Hawtrey was right. We should keep our eye on wages.