Influential economists are calling on the Fed to let go of inflation

The Fed's over-fixation on a 2% inflation target has blinded it to its principal duties, making it harder for markets to trust policymakers’ judgment.

That’s according to Allianz chief economist Mohamed El-Erian, who recently told CNBC that the U.S. central bank risks overreacting to stronger-than-expected economic data.

“Rather than be strategic, this Fed is overly data dependent, and has turned into a play-by-play commentator,” El-Erian said. “That’s not the role of the Fed.”

Instead, policymakers “should be more strategic,” he explained. Otherwise, they risk keeping interest rates too high for too long, straining households and the economy.

At the core of El-Erian’s argument is that the Fed needs to “politely” reevaluate its 2% inflation target. “It may well prove that the economy is stable nearer to 3%. I don’t think that’s going to de-anchor inflation expectations,” he explained.

The New York Fed’s latest survey of consumer expectations shows Americans expect year-ahead inflation to remain at 3%. On a three-year horizon, inflation expectations fall to 2.6%.

Many traditional economists say inflation expectations influence actual inflation because consumers adjust their behavior based on whether they expect prices to rise substantially or not.

If that’s the case, the Fed could be stuck between a rock and a hard place; on one hand, a higher inflation target may not be a problem in itself. On the other hand, it could reinforce inflation through consumer behavior.

A controversial topic takes center stage

As Creditnews recently reported, aiming for a higher inflation target—explicitly or not—would be a highly controversial move.

On one side of the debate are Harvard economist Jason Furman and Moody’s Analytics chief economist Mark Zandi, who believe that inflation can stabilize closer to 3%. That means central bankers can cut rates now without being overly worried about rampant inflation accelerating.

On the other hand, top officials, like St. Louis Fed president James Bullard, say abandoning the 2% target betrays the central bank’s congressional duty to maintain price stability.

Bullard views 2% inflation as “an international standard that was developed in the 1990s.” Abandoning it would be a “disaster,” he claims.

Despite being an international standard, the logic for a 2% target isn’t always clearly laid out. Even the Fed provides a nonchalant explanation for why it maintains this target, claiming that 2% is “most consistent with the Federal Reserve’s mandate for maximum employment and price stability.”

That being said, higher inflation targets in advanced economies aren’t that unusual. For example, the Reserve Bank of Australia targets annual inflation between 2% and 3%, while the Reserve Bank of New Zealand sets 1% and 3% as the appropriate range.

Whether the Fed moves the inflation goalposts or not, central bankers are under a lot of pressure to start cutting rates sooner rather than later.

The hidden cost of keeping rates high

Richard Koo, chief economist at the Nomura Research Institute, believes the Fed wants to lower rates as soon as possible given the massive size of bank reserves that are collecting interest.

“The central bank will really want to lower rates so it won’t have to pay so much interest on excess reserves,” he said in an interview with Bloomberg. “A lot depends on where the economy is going.”

In a separate interview, Koo told CNBC that current U.S. reserves are roughly 1,700 larger than before the 2008 financial crisis, which partly explains why rate hikes haven’t had the same effect on the economy as before.

“So much is on interest rates, and interest rates will have to go much higher to get the same effect it did have before excess reserves were at this magnitude,” he explained.

According to the Board of Governors of the Federal Reserve System, the Fed has been paying interest on bank balances held at the central bank since late 2008 as part of its lending program.

As the San Francisco Fed explains, “Paying interest on reserve balances was designed to broaden the scope of the Fed’s lending programs to address conditions in credit markets while maintaining the federal funds rate close to the target.”

Several other central banks, including the ECB, also have the authority to pay interest on reserves.