The Fed is stuck looking back as the economy advances

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About the Author: David Beckworth is a Senior Fellow at the Mercatus Center at George Mason University and a former international economist at the United States Department of Treasury.

The Federal Reserve is waging a historic campaign to break the back of inflation. It is now on track to raise its interest rate target to 5% by early next year and is expected to shrink its balance sheet by $2 trillion over the next few years. If all goes according to plan, the Fed will have tightened monetary policy more aggressively than at any time since the early 1980s. These aggressive efforts, however, have pushed the US economy to the brink of recession.

The Fed finds itself in this situation because it wants to bring inflation back to its target level of 2%, but also relies on inflation indicators that are lagging behind the evolution of the rest of the economy. In particular, the Fed pays close attention to wage inflation, rent inflation, and services inflation to estimate the direction the headline inflation rate is heading. These indicators have been slow to show that the economy is overheating in 2021 and, therefore, slow to show the sustained surge in inflation. Similarly, these indicators will be slow to show the weakening of the economy stemming from the tightening of monetary policy by the Fed and, therefore, slow to show the reversal of the inflationary surge. This means that the Fed will likely maintain an overly tight monetary policy for too long and cause a recession that could in theory be avoided.

The Fed is therefore stuck between a rock and a hard place. He wants to end the unpopular inflation spurt, but only seems able to do so by creating an equally unpopular recession. There doesn’t seem to be an easy way around this quagmire, but the Fed can learn from this experience to help it avoid such situations in the future. These lessons relate to the Fed’s relatively new monetary policy framework, called the flexible average inflation target, or FACT. This framework was adopted in August 2020 and is a form of inflation targeting that requires the Fed to catch up to past periods when inflation falls below 2%. The goal is to keep the medium rate close to 2%.

The first lesson is that the FACT causes the Fed to rely more on lagging indicators, as it requires pushing the average inflation rate above 2% after undervaluing it during a recession. In the case of the pandemic recession, the Fed’s monetary policy-setting committee declared between September 2020 and November 2021 that the take-off from its 0% interest rate target would only occur when “inflation will have reached 2% and is on the way to moderately exceeding 2%”. % for a while.” In other words, bringing the average inflation rate down to 2% has forced the Fed to focus on the current and past values ​​of inflation which, as noted above, react with a shift to monetary policy Some observers argue that the Fed should have instead taken a more precautionary and forward-looking approach to inflation.

The second lesson is that FAIT, like most inflation targeting frameworks, suffers from a knowledge problem. Specifically, central banks that target inflation need to know whether inflation is caused by supply shocks or demand shocks. Supply shocks are disturbances in the productive capacity of the economy, while demand shocks are changes in spending in the economy. Central banks can only respond productively to demand shocks, but it is impossible to know which shocks are causing inflation in real time.

Former Fed Chairman Ben Bernanke, writing on these pages, acknowledged this knowledge problem for DONE, but framed it in terms of Fed officials struggling to know when the economy is back. at full employment. In other words, excessive spending pressures created by demand shocks can push the economy beyond full employment and create unwanted inflation. However, one cannot tell that this has happened by simply looking at inflation. FACT forces the Fed to look at inflation and try to guess what is causing it. This can be seen in the Fed’s confusion over the causes of inflation in 2021 and its delay in responding to them.

Both of these lessons suggest that significant changes are needed for US monetary policy. First, the Fed needs to modify its FACT framework to minimize the knowledge problem. The Fed can achieve this by focusing its efforts directly on demand pressures in the economy. In other words, the Fed should aim for stable growth in total dollar spending rather than targeting inflation. This approach avoids knowledge problems related to inflation and keeps the dollar size of the economy anchored. It’s much simpler.

Second, the Fed needs to rely more on forward-looking indicators informed by better data. One way to achieve this is to use big data combined with artificial intelligence. Our growing digital business generates insights from online searches, social media interactions, financial transactions, and more. What is called big data can provide real-time knowledge of the economy. Applying AI to this data could reveal economic connections that would help predict economic activity. AI is currently solving health puzzles, creating original art and prose, and programming computer code. It could also be used by the Fed.

Together, these two innovations would help the Fed avoid future inflation crises. They would make its job easier, since the central bank would only care about the stable growth of total dollar spending and would do so using real-time forecasts that are continuously assessed and updated by AI. In other words, these changes would automatically reduce the risks of a new surge in inflation. Hopefully the Fed considers them in its next review of its monetary policy framework in 2024-2025.

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