Smart fiscal policy could help the US Fed do its job properly

Federal Reserve Chair Jerome Powell briskly dispensed with the idea of raising the central bank’s inflation target in his recent speech at Jackson Hole.

- CLIVE CROOK

But the idea isn’t going away. It has influential supporters, and they make a strong case. What’s more, the US central bank could raise the 2% target tacitly while insisting it has done no such thing. This might be the likeliest outcome.

It would be a pity. The better answer is to keep the 2% target and strive to hit it while acknowledging the limits of what the Fed can do on its own. Bringing fiscal policy to bear is the key. If that could be done, the Fed’s job would be easier and the costs of keeping inflation in check would fall.

There are two main arguments in favour of raising the target. The first says the benefit of reducing US inflation from its current headline rate of 3.2% to 2% would be so small that the cost (lost jobs and output at best and maybe a recession) isn’t justified. But this reasoning also applies to raising the target from 3% to 4%, or from 4% to 5%. At each step, the difference in inflation looks trivial and the cost of reversing it is not. This logic says the target is no longer binding, which makes holding inflation at any given level much harder. The second case for a higher target avoids this slippery slope. It says that inflation of 2% is too low, and if the target were a bit higher, it would better serve the US economy.