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Alexander William Salter: The Federal Reserve Should Stay Focused on Price Stability

Using monetary policy to support an already-stabilizing financial system would be a mistake. Amid lingering inflation and financial-market turmoil, the Federal Reserve raised its interest-rate target to 5 percent on Wednesday. To their credit, Chairman Powell and the FOMC (Federal Open Market Committee) were evidently more worried about price pressures than about bank-balance sheets. Indeed, this was the right move. We have other tools to stabilize the financial system. Monetary policy should focus on inflation.

Recent data show that inflation is still a problem. The Personal Consumption Expenditures Price Index (PCEPI), which is the Fed's preferred metric, rose 0.6 percent in January. That's 7.2 percent on an annualized basis. Likewise, the Consumer Price Index rose 0.5 percent in February, or 6.0 percent annualized. When adjusted for inflation (and volatile food and energy prices are excluded), the new fed funds' target of 5.0 percent is somewhere between -2.2 and -1.0 percent. In other words, it looks like real interest rates are still negative.

Most economists think the neutral interest rate – the inflation-adjusted (or real, as economists call it) rate that brings short-run capital markets into balance – is between 0.25 and 0.5 percent. Hence, we still have some ground to make up before we achieve neutral monetary policy. We may be closer than it seems, if trend inflation is a more accurate predictor of future price hikes than the annualized one-month rate. Nevertheless, it's likely too early to let up.

But what about banks and other financial institutions? When interest rates go up, bond prices go down, and many troubled banks have adopted a capital structure that assumed rates would stay low, meaning it was safe to load up on long-term government debt and mortgage-backed securities. Some argue that the Fed must take this pressure into account when making its interest-rate decisions. If whipping inflation means risking a financial panic, perhaps (the argument runs) we should take a pause before increasing rates further.

I disagree. First, it should be stressed that there are ways to deal with ongoing financial risks. But, more to the point, a good rule of economic policy is one instrument, one goal. That means when monetary policy uses the fed-funds rate as its instrument, it should have only one purpose in mind: price stability (ideally – a man can dream, can't he? – with the objective of targeting nominal gross domestic product (NGDP).

Achieving this, however, would require recognizing that the Fed's role as a last-resort lender is distinct from its monetary responsibilities. It would also require people to consider that the Fed's strategy, in cooperation with the Treasury, is too accommodative of irresponsible banks. The Fed's new lending facility and the Treasury's apparent guarantee of uninsured deposits are a case in point. I, for one, think this weakens basic market discipline and creates more problems than it solves.

Yet we must recognize that moral hazard isn't new. It's been a problem in our financial system at least since the Continental Illinois bailout in 1984. Indeed, heads I win, tails the taxpayer loses has been the de facto strategy of bank executives for decades. And while that is Washington's fault, it shouldn't affect the Fed's conduct of monetary policy.

For the time being, it appears financial markets as a whole are tolerably stable. Consider two popular measures of financial turmoil: the stress indexes of the Office of Financial Research' and the Federal Reserve Bank of St. Louis. Both of these are normalized to zero, which indicates average turbulence levels. OFR's is currently hovering at 0.56, and the St. Louis Fed's is currently 1.57. For comparison, these numbers were 9.49 and 5.29 at the height of the pandemic. Even then, the financial system was never at risk of meltdown. In 2008, when things really were dire, the numbers were 29.32 and 9.09. Of course, things can change quickly in financial markets – bank balance sheets have a tendency to evaporate (in the words of Ernest Hemingway) gradually, then suddenly – yet as far as we can tell, a 2008-like panic isn't on the horizon.

A word of caution before concluding. If we're talking about monetary policy, it would be foolish not to mention money. Interest rates by themselves tell us only so much. M2, a popular measure of the money supply, has actually fallen since spring 2022, which is extraordinary. Meanwhile, the broader Divisia monetary indexes, which weigh the components of the money supply by their moneyness (liquidity), are also shrinking a bit. This suggests tight liquidity conditions, especially relative to market expectations.

Rules of thumb are useful to guide policy. I'm inclined to agree with Steve Hanke and Manuel Hinds, who recently argued that a good strategy for price stability is 5–6 percent growth in the money supply per year. While this growth rate is not a matter of economic necessity, it's worked well in the past. Dismissing it would be imprudent.

Ultimately, it's up to the Fed to tame inflation. Nobody else can, because nobody else has the tools to do so. Other government agencies, along with additional (nonmonetary) Fed powers, should focus on balance sheets and financial integrity. Looking at interest rates, we're not yet where we need to be. But we are close. Looking at liquidity, we might have overcorrected. My gut says the Fed should stay the course with continued 25-basis-point hikes until inflation-adjusted rates are unambiguously positive, provided it's carefully watching monetary conditions as well. This may be unsatisfying, but it's the best we can do in an environment of widespread policy discretion – and that may be the strongest argument for reforming the monetary-policy process from the ground up.

We have other tools to stabilize the financial system. Monetary policy should focus on inflation.

Alexander William Salter is the Georgie G. Snyder Associate Professor of Economics in the Rawls College of Business at Texas Tech University, a research fellow at TTU's Free Market Institute, a Sound Money Project senior fellow, and a Young Voices senior contributor.

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Posted: March 27, 2023 Monday 06:30 AM