Worry less about inflation and more about recession

Any move by the Federal Reserve is the subject of concern and debate, as it should be. President Donald Trump has gotten involved in that debate, breaking a tradition of recent decades of presidential silence about Fed policy. He is "not even a little bit happy" about higher interest rates.

Some economists join Trump in thinking that the Fed is raising them too quickly. Others side with the Fed: Harvard professor Martin Feldstein, a longtime adviser to Republican presidents, argues that we need interest rates to be high enough that they can be brought down to stimulate the economy in the event of a recession.

On the question of whether the Fed is being too aggressive, some agnosticism and equanimity are called for. If the Fed has erred in either a hawkish or a dovish direction, it has erred only slightly. (Fed Chairman Jay Powell's comment that interest rates are now "just below" a neutral level suggests as much.)

Both unemployment and inflation remain significantly below the average of the last 50 years. Expected inflation is running near the Fed's 2 percent target. You can't reasonably ask for a much better performance, especially if you accept that inflation target.

We should use this moment of relative monetary calm to consider deeper questions, such as whether that target is the right one. Former Federal Reserve Chairman Paul Volcker thinks it is too high and allows too much debasement of the currency over time, pointing out that "a 2 percent inflation rate, successfully maintained, would mean the price level doubles in little more than a generation."

If Volcker is right, we should move the target from the 2 percent target to something closer to 0. He argues that lower inflation would not risk raising unemployment or turning into a dangerous deflation. But if he casts doubt on the costs of reducing the inflation target, he does not establish that this course would have large benefits. He does not, that is, establish that persistent 2 percent inflation is worth worrying about.

A high and highly variable inflation rate adds uncertainty to the economy, frustrating households and businesses as they try to make their economic plans. But if the Fed keeps inflation moving in a narrow band around a low average, that problem dwindles. Whether that average is 0 or 2 matters less than that it's predictable.

The real failing of the current monetary regime is not that it generates too much inflation. We haven't had ruinous levels of inflation since the early 1980s (something for which Volcker's own chairmanship deserves great credit).

We have, however, had a severe recession and a weak recovery, beginning a decade ago, and it is not at all clear the Fed is well-equipped to prevent a recurrence.

There are several reasons for concern about how the Fed will respond to the next downturn. Because it targets inflation, it may be tempted to tighten money inappropriately after a negative supply shock. In 2008, for example, higher oil prices seem to have led to a more restrictive Fed policy than warranted.

Stabilizing the business cycle requires treating increases in inflation differently if they are caused by a lower money supply or increased public demand for money balances, on the one hand, or a reduction in the availability of a key resource on the other. The stricter the inflation-targeting regime, the less likely the Fed will be to make those distinctions.

Another possible complication during the next downturn: Because interest rates have been generally declining for a generation and the Fed typically relies on reductions in interest rates to boost the economy, it may find itself with little ability to help in the next recession.

This is why Feldstein wants higher rates now. That solution, though, creates problems of its own. It requires a more restrictive policy, and thus higher unemployment and lower economic output, than economic circumstances themselves would dictate, just to preserve the central bank's room to maneuver. It risks starting recessions in the cause of being able to fight them.

Since 2008, the Fed has taken to paying banks interest on their excess reserves. This policy allowed it to recapitalize the banks during the financial crisis without creating runaway inflation. But it also, as a new book and study explain, undermined the Fed's efforts to promote recovery.

The Federal Reserve may be tempted to dismiss Trump's criticisms as off base and politically motivated, especially since it seems to be steering monetary policy pretty well at the moment. But it should not be complacent about how prepared it is in case it hits a rock.

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Ramesh Ponnuru has covered national politics and public policy for 18 years. He is an author and Bloomberg View columnist.