Fed chairman Jerome Powell is increasingly under fire for his apparently inability to take inflation seriously or admit it may be more than “transitory.” There’s been much talk of tapering the Fed’s enormous asset purchases, yet—as is typical for the Fed, actual action remains scheduled for some nonspecific time in the future. And if the economy weakens, as an increasing number of observers expect it to do, the Fed will surely chicken out on tapering and keep the money spigots open.
Yet as recently as August the Fed and its officials routinely warned that there wasn’t enough inflation and that the central bank must take steps to get price inflation up to the “2 percent” goal.
Indeed, for the past decade this concern over too little inflation has been a common narrative. Moreover, the 2 percent inflation target is framed in the financial press as simply an assumed necessity. The inflation target is treated as if it were a timeless metric, and (apparently) everyone agrees Fed policy ought to be guided by this target. Moreover, it’s part of a dangerous package of policies including the payment of interest on reserves, and Fed purchases of long-maturity bonds. The result is a chaotic economy heavily manipulated by Fed intervention.
But what’s so great about 2 percent inflation anyway? Why do central bankers insist it’s so important? And perhaps far more important is the larger question: What effect is the inflation target having on the boom-bust cycle and on economic prosperity?
The answers to these questions are explored and explained in Brendan Brown’s book The Case against 2 Per Cent Inflation: From Negative Interest Rates to a 21st Century Gold Standard (Palgrave Macmillan, 2018). Brown comes to the topic with considerable expertise. Currently Brown is a founding partner at Macro Hedge Advisors, and he’s the former head of economic research for Mitsubishi UFJ Financial Group.
At the core of Brown’s analysis is the fact that the world of the 2 percent target (TPT) is something new—and worse—than what came before. It’s not just the same old monetary policy but with slightly higher inflation targets. No, the era of the TPT is different, Brown explains, because it is part of the fundamental shift to “unconventional monetary policy.”
Ignoring the Monetary Base
One of the key changes inherent in the TPT is the fact that central bankers moved away from managing the size of the monetary base, and have instead embraced targeting price inflation directly. That is, before the Great Recession—and especially before the reign of Alan Greenspan—central bankers used changes in the monetary base as the metric for how much the money supply was to be inflated.
This distinction, Brown notes, is important because when the monetary base is the “pivot” for monetary policy, market mechanisms are still largely able to function. Under these conditions, there are no attempts to directly manipulate interest rates and the notion of negative interest rates is something for the realm of fantasy.
Things are quite different under a TPT standard. In the era of TPT, an arbitrary goods price inflation rate becomes the pivot for policy, and the central banks intervene directly to force up price inflation and manipulate interest rates. This can be done through the new and novel method of paying interest on reserves (IOR) and through the central banks’ large-scale purchases of long-maturity government bonds.
The Fed Adopts New Tools to More Forcefully Manipulate Financial Markets
Why did the Fed need these new tools? As Brown shows, the Fed had lost faith in letting markets work with old-fashioned increases to the monetary base. With the Fed engaging in unprecedented new rounds of monetizing debt, Fed officials surely feared interest rates could rise without more direct control. Brown writes how the new monetary regime
was very different from an emergency increase in monetary base designed to pre-empt a contraction of the money supply which could intensify the economic downturn. Rather it was a deliberate experiment to gain new control over short- and long-term interest rates, subjecting these to incessant manipulation, and alongside the giant expansion of the Fed’s balance sheet served key non-monetary purposes—including the subsidization of mortgages.
This set the stage for enormous money supply inflation designed to prop up price inflation to the 2 percent target. But the Fed also kept failing to meet this 2 percent goal in the decade following the Great Recession. This was partly because at this time many forces of disinflation were at work. Brown continues:
In pursuing their target under the 2% inflation standard, central bankers and their political masters have experienced much frustration. The natural rhythm of prices has been downwards—reflecting rapid globalization and digitalization. Central bankers have sought to suppress this (natural rhythm) and drive prices higher on a sustained basis. They have encountered pushback from a combination of circumstances…. They have doubled up, developing non-conventional monetary tools designed to increase the effectiveness of their policies aimed at “breathing in inflation.”
All of this, however, remains an experiment of huge increases in money supply coupled with policy tools that are hardly tried and true. So, Brown warns:
These tools have carried serious side-effect. In particular, they destroyed the signalling mechanisms in the long-term interest rate market essential to the well-functioning of a capitalist economy. While too early to know what the eventual cost of this dysfunction will be, there are already indications that the consequences are serious.
Messing Up Market Prices
The effects are serious indeed, because we’re now in a world where short-term rates are heavily controlled by the payment of interest on reserves. Meanwhile, long-term rates are subject to the manipulation of Fed asset purchases. Having wrenched interest rates further from the markets, the “signalling mechanisms” no longer function and entrepreneurs interpret low interest rates as a signal to pour more money into longer-term projects. This reduces near-term investment in consumer products while a rising money supply simultaneously encourages more spending on consumer products.1 Not surprisingly, price inflation in consumer goods will follow. This, of course, is exactly what the central bankers want in their pursuit of TPT, and all these false signals from interest rates can mean “mission accomplished.” But, as Brown notes, this comes with a price of “dysfunction,” as artificially low interest rates have led to immense amounts of malinvestment—which will eventually collapse.
Fed economists likely know there is a big risk here, but political realities likely won’t allow for any easy way out. This is for at least two reasons. One is expectations. It is now assumed that any sign of “deflation” or a worsening economy will bring even more stimulus, and as Brown notes,
In the bizarre and destabilizing world of the global 2% inflation standard…. [t]he assumption becomes that the central banks will ease policy—meaning lower real rates than otherwise in the short and medium term—in response to any setback on the road to getting inflation back to 2% (from territory below). The consequences may well be a further intensification of asset inflation such as we witnessed through 2017.
This assumption is now built into Wall Street’s view of the central bank. The failure of the Fed to intervene in this fashion would likely bring bearish equity markets, and few incumbent politicians want to see that.
The Quest for Negative Interest Rates
But perhaps the biggest issue is the fact the Fed is desperate to get inflation rates up so that it has room to maneuver in case of a new recession or financial crisis. As it is, both real and nominal interest rates are now too close to zero for the Fed to force down rates very far in the name of stimulus. That is, the Fed wants to be able to push rates down a long way in order to stimulate the economy, but nominal rates can’t go much below zero. On the other hand, if the Fed can get the inflation rate—and inflation expectations—up to 2 percent or higher, then the Fed can push real rates down much further below zero.2
Brown knows where all this leads. Indeed, we’re already there. One problem is a famine in interest income, and a hunt for yield that becomes ever more risky. The result is an increasingly fragile financial system. Other problems include mounting malinvestments and the inability of regular investors to save and invest in any fruitful way. Rising inequality, widespread defaults, and slowing economic growth are all outcomes we can expect.
Fortunately, Brown isn’t content to just outline the problem. He provides a blueprint for a step-by-step return to relative normalcy. For him, the ideal is a gold standard. But failing that, he allows for several other options in which money would be relatively sound and reliable in contrast to today’s increasingly outlandish monetary experiments. Brown is nothing if not pragmatic and deeply steeped in the real-world workings of financial markets. His book would be a very useful addition to the reading list of any reader interested into the specific details of monetary policy and the dangerous world the central bank has built.
1. For a full explanation of this process, see chapter 5 of Jesús Huerta de Soto, Money, Bank Credit, and Economic Cycles, trans. Melinda A. Stroup, 4th ed. (Auburn, AL: Mises Institute, 2020).
2. For more see Bob Murphy’s recent interview in The Austrian: I agree that the ultralow interest rates have not done anything benign or good for us, that they present a problem. Somebody from a Yellen perspective or a Paul Krugman, what they mean when they talk like that is to say, ‘We can go ahead and push down interest rates, like I say, down to basically 0 percent and then we can engage in QE, even, and try to raise inflationary expectations in the future.’ And the reason for doing that is to lower the real interest rate. So they’re saying once nominal rates get to zero (and yeah, they actually could go slightly negative, but they couldn’t go to –10 percent in nominal terms; even money market funds would switch to hold cash), how do you lower the real interest rate? You’ve got to raise expectations of future price inflation so that in real terms even a 0 percent nominal rate translates into –10 percent.
But, they’re coming from a Keynesian perspective when they talk like that. They think what you want to do is make people want to consume or invest now and the way you do that is you lower real interest rates.