Policy rooted in flawed economic theories

OPINION:

After years of frustration, the Federal Reserve believes it has accomplished its goal of 2 percent inflation. In reality, international oil markets did much more than its interest rate policies to raise prices and the Fed should abandon that target altogether.

The Fed is charged by Congress to accomplish full employment and stable prices, but older Americans suffering low CDs rates know that 2 percent is hardly stable prices — especially with their expenses highly concentrated among inflation prone services like health care.

The Fed’s policy is rooted in flawed economic theories.

The Phillips Curve postulates that as unemployment falls, workers get more bargaining power and push up wages and prices. Also, economists believe near zero inflation is not sustainable, because as inflation gets below its sweet spot — currently designated by the Fed as 2 percent — prices for discretionary items like new cars and dry cleaning could actually fall, businesses become reluctant to invest and the economy plunges into recession.

With headline unemployment near historic lows, inflation should rocket but it’s still fairly tame. Most pricing pressure comes from restrictions on new pipeline construction that would better move shale oil to refineries, burdensome business regulations and sanctions against Iraq, the meltdown in Venezuela and the Russian-OPEC agreement to reduce oil production — none of those have much to do with U.S. labor markets.

Finally, economists believe that clarity from Fed policymakers about future plans for interest rates can provide an anchor for inflation and encourage business investment. Since Ben Bernanke became chairman in 2006, the Fed has tried to telegraph its policy moves in advance as much as circumstances permit.

However, when the Fed expresses its policy intentions, it usually cautions future actions will depend on events as those develop. Earlier this year, the Fed scotched plans to raise interest rates further in response to stock and bond market turbulence — such behavior make the Fed’s communications about policy intentions nearly useless for long-range business planning and investment.

Five factors have unhinged inflation from the observed unemployment rate.

First, with businesses adding about 180,000 jobs a month and wage increases still fairly tame, the economy cannot be near full employment.

During the Obama years, adult labor force participation fell dramatically thanks to more generous Medicaid, food stamps and Social Security disability benefits. The Trump administration is tightening up as it can and that is pushing prime working age adults back into the labor market.

Second, more seniors are working these days, because they are healthier than were their parents, the demise of many benefits defined pensions and poor performance of CDs and high grade bonds.

Third, consistently weak growth in Europe and easy credit policies in China put a lot of downward pressure on U.S. import prices.

Fourth, the increasingly prominent technology sector uses fewer buildings and machines to create value than old-line manufacturing to create value — software and autos both require expensive R&D but making more copies of a new app does not require the same capital investment as increased demand for F-150s.

Fifth, Amazon and smartphone apps permit consumers to compare prices more easily. Along with reduced consumer loyalty to big brands like those offered by Unilever, those limit price increases for many household and business necessities.

Influential macroeconomists have models that reduce the U.S. economy to a handful of equations — with little or no consideration of the abovementioned forces — that purportedly show if the Fed would merely communicate a preference for inflation above 2 percent, we would get more inflation and stronger economic growth. That’s silly.

Instead, it would be better for the Fed to target a growth rate for overall spending at 4.5 percent or 5 percent, which adds up to 2.5 percent to 3 percent for real growth and 2 percent for inflation. That would imply a target rate of inflation above 2 percent when growth is subpar and below 2 percent when the economy is robust.

The Fed should take some unconventional steps to boost spending as needed. It could offer seniors and other citizens access to interest-bearing accounts it now limits to banks, hedge funds and money managers — when spending is slack, directly inject cash into consumer accounts. And it could purchase state and municipal bonds for new infrastructure projects as the economy slows.

Spending, not inflation, drives growth and prosperity, and that’s where the Fed should focus.

• Peter Morici is an economist and business professor at the University of Maryland, and a national columnist.