The Cato Institute’s Alan Reynolds explains the limits of Federal Reserve power here.
We have all been watching a long mystery with no ending: What the Federal Reserve governors are trying to do, how they intend to do it and why they imagine their efforts will work.
The key questions boil down to two: (1) What target should the Fed aim at, and (2) what policy instruments should it use to hit that target?
The Fed’s only explicit target — an unemployment rate of 6.5% — was shrewdly discarded as “outdated” as that target grew near. Actually, the idea of focusing on unemployment is outdated, since it presumes that high unemployment guarantees low inflation — as though stagflation in 1975 or 1982 could not have happened.
Why not simply target inflation? Ben Bernanke advocated inflation targeting before 2002, when he became Fed chairman. On Nov. 21, 2002, he gave a speech warning that inflation was too low, threatening deflation.
Today, as in 2002 or 1998, many are again warning that inflation is too low — just 1.1% last year when gauged by the deflator for personal-consumption expenditures (PCE), or 1.5% over the past 12 months, according to the March consumer price index.
But the trouble with basing future policy on past inflation news is that inflation is always lower before it moves higher. PCE inflation rates of 0.8% in 1998 and 1.3% in 2002, for example, were followed by 2% inflation in 2003, 2.4% in 2004, and 2.9% in 2005.