Why The Federal Reserve Accepted 2 Percent Inflation As The Norm
The Fed’s message that rates will stay near zero for a long time—and that inflation will be allowed to exceed 2 percent to make up for past misses—is meant to increase inflation expectations.
Americans should be entitled to a more substantial review that also calls into question the very foundation of the Fed’s operations. Such a review should consider alternative monetary frameworks, including NGDP targeting.
[1] The Fed’s post‐2008 operating framework—the so‐called floor system—is an important part of the monetary framework. Inflation has been avoided (so far) by the Fed’s payment of interest on excess reserves (IOER), which discourages new base money from being lent out and influencing nominal income. Under the floor system, the IOER rate becomes the key policy rate and is set administratively by the Board of Governors. This arrangement differs substantially from the pre‐2008 operating system in which the FOMC set a target rate for the federal funds rate and then supplied the reserves needed to meet demand at that rate. Under the current system, the demand for reserves becomes perfectly elastic (flat) at the IOER, and small movements in the supply of reserves have no effect on the fed funds rate (see Ihrig, Meade, and Weinbach; also Selgin).
[Cross‐posted from Alt-M.org]
This article first appeared at the Cato Institute.
Image: Reuters.