The Financial Stability Risk to the Fed’s Target

The Federal Reserve is on a quest to return inflation to 2%. What is generally not considered is how much that target is specific to the period in which it was set, which has large implications for their success. The Fed’s mandate has long been full employment and price stability, but a numerical target for inflation was never specified before 2012. In January of that year, Ben Bernanke, who was chair at the time, announced the selection of 2%. That was modified slightly in the Covid pandemic to be an average, rather than a hard target. While that may appear to be a pedantic distinction, it implies a larger problem. In the event of significant adversity, they may have to choose among undesirable alternatives. How they will decide remains to be seen, but their behavior has already contributed to insolvencies among banks. Odds of more trouble are rising.

It is useful to consider the historical context in which they chose 2%. In Chart 1 we show annual inflation for the Fed’s chosen series, the Personal Consumption Expenditure Deflator from its inception, and the Consumer Price Index for comparison:

Inflation modestly above zero occurred in the early 1960s as well as in the era of the Fed’s 2% decision. Prior to that there was outright deflation in the Great Depression (an outcome that has presumably been ruled out as a result) but also inflation in double-digits in the 1940s as a result of World War II when wartime price controls were removed. The salient point here is that low inflation cannot be relied upon to be stable, but such were the conditions when the Fed chose their target.

Paul Volcker has emerged as a central banking folk hero under these circumstances, and it appears that his successors in office today fear a loss of the Fed’s authority if they do not take the responsibility of once again bringing inflation under control. They have raised their target interest rate 500 basis points since March, 2022. In so doing they have achieved an outright shrinkage in the money supply rate of change that surpasses anything in recent history (including Volcker), as shown in Chart 2:

The Fed has certainly reacted with alacrity, but whether they have considered all of the implications is not clear. The sudden demise of the Silicon Valley and Signature banks in March and First Republic in May are an unmistakable warning shot. The Fed’s aggressive interest rate increases revealed weaknesses in their businesses which turned into bank runs in the new era of instantaneous communication.  The most troubling thing, perhaps, was that they occurred after a significant deleveraging of the financial system following the Global Financial crisis of 2008-09:

If that could occur following such a period of debt reduction, consider what could be occurring in the nonfinancial sector of the economy where debt has continued to ascend to the heavens, as Chart 4 shows:

The Fed cite their mandates of full employment and price stability frequently, but that list is incomplete. They have a de facto mandate of financial stability as well. Their reaction appears out of scale to the risk in the financial system from debt levels that have built over a period of decades. In fact, it is arguable that the risks are all the greater from the rise in debt that occurred in response to the low interest rates of the last decade.

Some factors that affect inflation are of limited duration, such as wars. But others are more persistent. Those that are more structural in nature are the more worrisome, since they may last and policymakers have limited scope to change them. Demographics are one, and those are going in the wrong direction for inflation today. The Baby Boomers, for all of their youthful foibles earlier, helped the cause of low inflation by working longer than expected, contributing to the supply of labor. But they are retiring, an important contributor to a labor participation rate that has been falling over the last couple of decades. Another reason for upward inflation pressure is receding globalization of supply chains which, led by China, put downward pressure on prices of manufactured goods over the last four decades.

These are structural reasons for less stability of inflation. But there is also component that is perceptual, yet important. Perceptions that inflation will remain stable themselves contribute to it doing so, and this is why the Fed appears adamant–for now–in their campaign. The problem is that their own previous behavior has contributed to the problem. In the post-GFC period they came to the rescue repeatedly when the stock market fell and threatened to derail economic growth.

This is very different from a world in which the monetary authority is committed to a simple rule that everybody understands. That existed in the seemingly long-ago past in the form of the gold standard. In its classic formulation, citizens could take their currency to the Treasury and ask for gold—and they would receive it, at a ratio that was set and fixed for years. Such a structured world was subject to disruption too, but not often. In the United States the gold standard was interrupted by the Civil War. Under President Lincoln the U.S. left the gold standard at the war’s outbreak in 1861 in response to the enormous pressure on prices. But it was a measure of the commitment to a clear monetary standard that there was an expressed intent to return, which did occur in 1879. “Resumption”, as it was called, put serious deflationary pressure on the economy in the 1870s. That continued for years, vividly expressed in the 1896 election campaign by William Jennings Bryan in his legendary “Cross of Gold” speech. But the fixed dollar value of gold remained about $20 per troy ounce until President Franklin Roosevelt ended it in response to its deflationary pressure in 1933. While private citizens could no longer redeem their currency for gold, foreign governments could in a modified version known as the Gold Exchange Standard that devalued the dollar by revaluing the ratio to $35. That policy was ended in 1971 when any conversion to gold was eliminated, and the rapid inflation of the 1970s followed. It fell to the Volcker Fed to restore some confidence in the monetary authority from 1980 to 1982.

History thus shows the benefit of stability in a monetary standard of some kind, although a return of a gold standard at this point is remote. The history also shows that it is subject to change as events require or suggest, but frequent adjustments such as those the Fed made in the last decade erode confidence that there are any rules at all. Having made the choices they did over the last decade they have fewer now, with a rising risk of financial instability due to current debt levels.

The result is that 2% inflation looks more like a choice that was made not because there is much about it that is replicable, but instead because it was easier at the time. While a declining money supply may make for weaker economic numbers in the near future, and falling rates of inflation for a time, the Fed’s target may require tinkering again in the long-term. In June Fed chair Powell said that “the process of getting inflation back down to 2% has a long way to go”. But he has so far seen only the early stages of what could become larger side-effects. A target more like 3-4% may become a topic for the Fed in the event of rising financial instability.

Reference: King, Stephen, We Need to Talk About Inflation, Yale University Press, 2023