EDITOR NOTE: Many people might have missed the nuance in the Federal Reserve’s announcement regarding its monetary strategy moving forward. Not only are they looking to “overshoot” their inflation target of 2%, they have also revised this figure to an “average” target of 2%. What does this mean, exactly? Well, considering that we undershot the target for a number of years, the Fed can sustain a much higher inflation rate, say 5%, to make up for it. The cost of living has risen quite unfavorably for many, despite the US economy missing the Fed’s previous inflation target. Imagine how much worse it will be once we overshoot it.
The US Federal Reserve has adjusted its official inflation target to be even more flexible and inflationary. The Fed has always been more inflationary than the Bundesbank and its successor, the European Central Bank, at least on paper. The primary objective of the ECB is price stability, following the Bundesbank legacy. Curiously, the ECB considers price stability to be given if price inflation is below, but close to, 2 percent. Only when this goal is achieved does the ECB aim to support other economic policies, such as full employment.
In the USA, the preferences look somewhat different. The Federal Reserve pursues three equally important goals. In addition to price stability, the Fed also wants to ensure moderate long-term interest rates and maximum employment. Therefore, a little more inflation to increase employment in the short term is easier to justify with the Fed's mandate than with that of the ECB. Moreover, the Fed has explicitly set its price inflation target at 2 percent since 2012, which means that it is inherently more inflationary than the ECB with its target rate of under, but close to, 2 percent.
With its recent change in strategy the Fed is going one step further. It now wants to accept and target price inflation rates of over 2 percent if the previous measured rate was below 2 percent. It is now aiming at an “average inflation target.” If, for example, the measured inflation rate is 1 percent for three years, then the Fed has no problem with an inflation rate of 5 percent, to make up the “shortfall.”
Since the US price inflation rate has mostly been below 2 percent in recent years, the Federal Reserve is opening the door to higher monetary inflation. The policy change has further increased the discretionary power in interpreting the Fed's price stability target. Considering that price stability literally means and is 0 percent price inflation, we have gone a long way down an Orwellian road.
It's important to realize that with this strategy adjustment the Fed simply legitimizes the path of higher money supply growth that it has embarked on and wants to continue on. In other words, the Fed was forced to make this adjustment to remain true to its inflation course. When the mandate is in the way, the mandate has to change. Therefore, the change in strategy does not come as a surprise but is the logical result of the Fed’s intention to continue to bail out an overindebted economy and finance the government. This year, the ECB will also review its strategies and possibly adjust them, i.e. make them more inflationary, thereby also consolidating and subsequently justifying the course it has already taken.
Although the strategy adjustment was to be expected, its symbolic power and long-term effects should not be underestimated. The quality of the dollar has declined. Price inflation can be expected to be higher than otherwise. This gives the stock markets further upward momentum. The euro is becoming more attractive relative to the dollar, at least until a strategy adjustment has also taken place in the eurozone. The most important insight of the Fed's more flexible objective is that central banks do not care for rules. They make the rules. They are in a symbiosis with their overindebted economies and the governments they finance. In the current situation, central banks have to maintain interest rates low and accelerate the printing press to keep debtors afloat. They have already ventured too far down the inflation path. The move to adjust their strategy becomes allowing for more discretion, and inflation is almost inevitable. Unsurprisingly and as illustrated by the recent Fed's policy adjustment, central banks do not hesitate to change their objectives if they regard it as necessary.
Originally posted on Mises Institute