Free Markets

Good Economic Policy Is About More Than Inflation

Monetary policy can't work optimally until we free up the economy in other important ways.


This time last year, we were in the depths of a global crisis. A mysterious disease was sweeping across the world, and governments shut down economies in an attempt to stop the spread. Right or wrong, these shutdowns brought our lives and livelihoods to a grinding halt. The unemployment rate in the United States reached nearly 15 percent, and measures of "underemployment" reached as high as 23 percent. Total wages and salaries fell by 6.5 percent in a single quarter.

The Federal Reserve took extraordinary action to cushion the fallout. Today the Fed is tolerating higher inflation to accelerate the recovery. But the time for this temporary overshooting is coming to an end.

Many libertarians are uncomfortable with the very existence of the Fed. I appreciate their passion for sound money and human freedom. But the Fed does exist, and it can adopt policies that are better or worse. To raise money and credit growth in a recession, the Fed lowers interest rates. To slow their growth to stop inflation, the Fed raises interest rates. At its best, the Fed makes sure that money and credit can grow at an even keel, thereby promoting stable prices and maximum employment.

Our country's deteriorating long-run growth has brought interest rates close to zero, even in normal times. To give themselves room to lower interest rates during recessions, Fed policy makers choose to target an average of 2 percent annual inflation, not zero. They hope that low, stable inflation will pose little harm as long as households anticipate it. When the Fed falls short of that target, they overshoot to raise the average back to 2 percent. Otherwise, interest rates would fall closer to zero.

The inflation we're seeing today gets us back on track to price stability by offsetting the deflation and disinflation of the last 10 years. This is painful for families. It's like medicine: bitter, temporary, and—if correctly prescribed—necessary. Every worker should demand a cost-of-living adjustment. Inflation means your wages should rise, too. Frankly, not all of us will get it. That's a sacrifice we did not choose.

The question is what's worse: a small decrease in your inflation-adjusted salary, or longer and larger layoffs during recessions? The Fed is betting that a bit of inflation today saves jobs tomorrow.

This solution is not perfect. We must demand better. Most importantly, we need to get the economy growing again—real long-term growth, not just a bounce back from 2020. Higher long-term growth would raise interest rates away from zero, allowing the Fed to target true price stability without becoming powerless in recessions.

The key ingredient for long-term growth is higher productivity. But the Fed is powerless to raise productivity, except indirectly through the boons of a long-lived economic expansion. As Fed officials often emphasize, growth-promoting policies are squarely Congress' responsibility. But until growth strengthens, we may be stuck with 2 percent average annual inflation.

Fed Chairman Jerome Powell (who is up for reappointment soon) and other monetary policy makers know inflation has now averaged 2 percent for the past five years. They have accomplished the backward-looking part of their recovery strategy. It is now time to look ahead. With the unemployment rate under 6 percent and over $4 trillion in additional spending on the horizon, isn't it about time to turn monetary policy accommodation down from max? Like in years following the global financial crisis, they should allow the labor market to fully tighten, but recognize that the path back to 3.5 percent unemployment may be a slow and steady climb.

Everyone else's patience as we exit the depths of the crisis deserves to be rewarded.