Bohanon & Curott: The Fed should have adhered to its target

The original justification for the Federal Reserve, founded in 1913, was to be the “bank of last resort.” It was designed to provide ready cash to commercial banks suffering from temporary liquidity problems in order to avoid unnecessary bank failures. The point was to forestall panics and economic downturns. The Fed was given enormous discretion to attain such ends.

However, as Milton Friedman and Anna Schwartz pointed out in their landmark study, the Fed used its discretion in the 1930s to contract the money supply and thereby turned an ordinary recession into the Great Depression.

In 1971, the United States fully abandoned the gold standard, giving the Fed total control over the supply of dollars. The Fed used its discretion to pursue easy money policies that caused the Great Inflation of the 1970s. Friedman proposed the Fed should get out of the business of trying to fine-tune the economy and instead simply expand the money supply at a consistent annual percentage rate. This, he argued, would generate a predictable, low, long-term inflation that would promote economic certainty, growth and stability. Numerous economists have argued for other versions of rules-based monetary policy. On paper, the Fed’s target of 2% inflation appears consistent with the idea.

However, after acting appropriately to stabilize the financial system during the COVID crisis of 2020, the Fed went wobbly on its 2% target. As inflation had been below target previous to the crisis, the Fed announced it would intentionally allow inflation to rise above 2% for an unspecified period.

The Fed went overboard. During the current recovery, the Fed has again abused its discretion, purchasing trillions in Treasury bonds and mortgage securities, flooding the economy with money and credit. This has led to escalating inflation, which hurts all Americans but is especially hard on lower-income households. Working this inflation out of the system will entail tight monetary policy that might cause another recession, which again will harm lower-income workers the most.

If the Fed had simply adhered to its 2% target in 2020, it would have been much more likely to generate just enough of a monetary expansion to prevent the economy from tanking, while keeping inflation nearer 2%. Instead, the Fed kept money too easy for too long. The problem with “discretionary” monetary policy is the same as with any addiction—the “I’ll just do it this one time” never really works out. Discretion versus rules? We’ll take rules every time.•

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Bohanon and Curott are professors of economics at Ball State University. Send comments to ibjedit@ibj.com.