How the Federal Reserve can gird for the next crash

For decades, the Federal Reserve was able to counter mild fluctuations in the U.S. economy by fiddling with short-term interest rates. Then the Great Recession happened. 

As the central bank kept reducing the so-called federal funds rate -- what banks charge other lenders for overnight loans -- in hopes of reviving the economy, it eventually hit what economists refer to as the “zero lower bound.” That’s because interest rates were so low that policymakers could effectively no longer cut them, depriving the Fed of its preferred antidote for a slowdown. Instead, they turned to an unconventional -- and far less effective -- treatment in the form of flooding the economy with money. 

Is there a way to preserve the Fed’s ability to cut rates even when they’re scraping bottom? Quite possibly. 

One proposal is for the Fed to raise its target rate of inflation from 2 percent to, say, 4 percent (or higher). The question, for consumers, businesses and economy at large, is how would raising the target rate of inflation affect average interest rates?

Interest rates depend on two things -- the desired rate of return plus a premium to cover expected inflation. For example, suppose you want to make a loan of $100 for a year, and in return you want to be able to purchase 4 percent more in goods and services when the loan is repaid. But if you expect, say, 6 percent inflation during the year, you will be repaid in dollars that aren’t worth as much. The interest rate you charge needs to include an adjustment for expected inflation. In this case you would want to charge 10 percent on the loan (the desired return plus the expected rate of inflation) so that when the loan is repaid it includes an adjustment for the rise in prices during the year. 

It is this expected inflation component of interest rates that changes when the Fed changes its target inflation rate. For example, when a five-year loan contract is negotiated, the actual rate of inflation over that time period is unknown. So the interest rate that is charged will include a premium to cover the expected rate of inflation. If lenders believe the Fed is going to allow the inflation rate to rise by 2 percent per year more than the previous level, and they also believe the Fed will do whatever it takes to hit the new inflation target, then lenders will raise the annual interest rates they offer by 2 percent to cover the expected loss in the purchasing power of the dollar when they are repaid.

Changing the Fed’s inflation target could affect the actual inflation rate in other ways. When workers bargain for an annual wage increase, they do not know for sure what the inflation rate will be. But if they expect inflation to rise, then they will ask for a bigger pay bump. Thus, when inflation is expected to be higher, wages will go up and firms will increase prices to cover the higher wage costs. Rising prices deliver the higher inflation that had been expected.  

For this to work, the credibility of the Fed is essential. When the Fed announces it will pursue a higher inflation target, people must believe that policymakers will be able to reach its new goal. If the Fed announces a 4 percent target, but people don’t believe it will be able to get inflation over 2 percent, then interest rates, wages and prices will not go up in response to the announcement. 

Prior to the recession, the Fed vigorously defended its inflation target of 2 percent, and inflation was relatively stable around this level. But after the 2007 downturn inflation fell below the 2 percent target, and try as it might the Fed has not been able to push inflation back up to its goal. If the Fed were to announce a 4 percent target in the near future, would people believe that actual inflation would respond, or would the failure to reach that 2 percent target instill doubt about the bank’s ability to hit an even higher target? 

That’s not something we can know for sure unless the Fed announces a new target. The Fed would likely succeed, at least eventually, in raising both expected and actual inflation by allowing the economy to overheat once it reaches full employment, but it could take awhile before people are convinced that inflation will rise to the Fed’s higher announced target.

The Fed did not have enough room to cut interest rates before hitting the zero lower bound when the recession hit. Raising the target inflation rate, which would increase average interest rates and give the Fed more space for rate cuts, is something the Fed ought to seriously consider.