The Fed has abandoned price stability — Congress must correct its course

Consumer prices are rising at more than a 10 percent annual rate and bond investors are expecting future inflation of 2 percent. Does this sound like price stability? Common sense says no, but the Federal Reserve says yes. The Fed argues that our current “transitory inflation” is nothing to worry about as they keep open the monetary spigots. The Fed is ignoring its Congressionally mandated duties with little pushback. With Democrats counting on the Fed to monetize their bloated federal spending plans, there is no mechanism to enforce Fed accountability. 

In 1977, Congress amended the Federal Reserve Act and explicitly directed the Fed to ”maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote the goals of maximum employment, stable prices, and moderate long-term interest rates.” While Congress gave the Fed three goals, until recently, the law has always been interpreted by Fed officials as imposing a dual mandate on monetary policy: price stability and maximum employment. The explicit goal of maintaining moderate long-term interest rates was presumed to follow if the Fed achieved the goal of price stability.

Given these Congressional mandates, how has the Fed been doing? Regarding the monetary aggregates, between December 2020 and March 2021, M2, a measure of transactions money balances, increased by 30 percent. Over the same period, real GDP declined by almost 1 percent. In other words, 30 percent more money is chasing only 99 percent of the pre-COVID-19 GDP.  

The news regarding the Fed’s price stability mandate is equally disturbing. Consider the annualized rate of inflation from the month-to-month changes in two measures of consumer prices — the consumer price index (CPI) and the personal consumption expenditure price index (PCE), the Fed’s preferred measure of inflation. 

When the inflation rate is above zero, consumer prices are rising. If consumer incomes are not rising as quickly, inflation reduces consumer purchasing power — aka, an inflation tax. Both measures indicate that inflation is positive in every month save one and, beginning in December, month-by-month statistics show prices rising at an increasingly rapid pace. By April, depending on the inflation measure, consumer prices were rising at an annual rate of between about 7.5 and 10.3 percent. 

The Fed argues that the recent string of high monthly inflation statistics is very likely to be “transitory” meaning that the Fed expects monthly inflation rates to decline in the near future as the economy opens up and the production bottlenecks disappear. Because they expect the recent spikes in monthly inflation to dissipate, the Fed believes there is no need to change the expansive monetary policy it believes is necessary to support an economic recovery. Meanwhile, transitory or otherwise, all inflation is a tax. It reduces consumer purchasing power and erodes the value of consumer’s monetary savings.

Recent open market committee statements suggest that the Fed is unlikely to react to additional consumer price inflation as long as investors’ long-run annual inflation expectations stay “anchored” at close to 2 percent. In effect, the Fed has de-emphasized if not abandoned the goal of price stability and replaced it with the goal of maintaining moderate long-term interest rates which in large part are determined by investor inflation expectations.  

The problem with this strategy is that the Fed’s own history shows that, in an environment of accelerating consumer price inflation, long-term interest rates will not stay moderate for long. No one knows how long bond investors’ inflation expectations will stay anchored at 2 percent when faced with additional months of bad inflation news and no Fed policy reaction. 

Somewhere between the great recession and the COVID-19 recession, the Fed decided price stability meant a constant 2 percent inflation rate. Worse still, Fed officials forgot what Paul Volcker told Congress in the first Humphry-Hawkins monetary policy hearing in 1981.

“I bring in price stability because we will not be successful, in my opinion, in pursuing a full employment policy unless we take care of the inflation side of the equation while we are doing it. I think that philosophy is actually embodied in the Humphrey-Hawkins Act itself. I don’t think that we have the choice in current circumstances — the old tradeoff analysis — of buying full employment with a little more inflation. We found out that doesn’t work, and we are in an economic situation in which we can’t achieve either of those objectives immediately. We have to work toward both of them; we have to deal with inflation. And the Federal Reserve has particular responsibilities in that connection,” Volcker said.

With the Fed monetizing the Federal deficit, and inflationary pressures building, where is the authority to question the Fed’s strategy and push it towards its congressionally mandated goals? The answer is the Congress of course, but with a Fed-compliant press and Democrats in charge and cheering on Fed easy money policies, the only remaining checks on the Fed are the minority party and outspoken academics and practitioners.

Paul H. Kupiec is a resident scholar at the American Enterprise Institute (AEI), where he studies systemic risk and the management and regulations of banks and financial markets.