A Nobel Prize-winning economist believes the Fed has overreacted to inflation without fully understanding its underlying cause.

In an interview with CNBC’s Squawk Box, Columbia University professor Joseph Stiglitz said the Fed’s rate-hike campaign doesn’t fix the inflation problem caused by Covid and the war in Ukraine.

Over the past two years, the “underlying source [of inflation] was very clear—it was a supply shortage generated by the pandemic, it was the war in Ukraine, it was demand shifts,” Stiglitz said.

“The Fed’s response of just raising interest rates wasn’t getting at that underlying source and in some ways made things worse,” he explained.

Stiglitz believes the Fed should have raised interest rates to no more than 3.5%. The current federal funds rate is 5.5%—a level that “distorts the economy not only here at home but globally” as well, he said.

The Fed raised interest rates aggressively to achieve 2% inflation—a target that Stiglitz said “was pulled out of thin air.”

“There’s no economic science behind that. No economic science says how fast you should go back to whatever goal, arbitrary as it is,” he said.

In Stiglitz’s view, the Fed’s job isn’t to bring inflation back to an arbitrary number, but rather to keep “inflation within guardrails.”

“Everybody realizes that we don’t have runaway inflation. We’re not Argentina. We have a stable economic system that’s working,” Stiglitz explained.

Stiglitz isn’t alone in his skepticism of the Fed’s inflation target. In fact, central bank researchers themselves are getting cold feet about blindly following an arbitrary target.

Arbitrary target built on “shaky foundations”

The Fed’s 2% inflation target has long been controversial. St. Louis Fed president James Bullard calls it “an international standard” that would lead to ‘disastrous’ consequences if abandoned.

Although the Fed’s top brass have never publicly questioned the target, central bank staffers certainly have.

A 2021 paper published by Federal Reserve Board economist Jeremy Rudd questioned a core assumption of the 2% target—namely, that inflation expectations are a key driver of actual inflation.

“A review of the relevant theoretical and empirical literature suggests that this belief rests on extremely shaky foundations, and a case is made that adhering to it uncritically could easily lead to serious policy errors,” he wrote.

In an article published in The New York Times, economist Neil Irwin explained how the 2% inflation target originated in New Zealand and “was plucked out of thin air to influence the public’s expectations.”

Other economists, including Harvard’s Jason Furman and Moody’s Mark Zandi, believe the Fed could achieve price stability with inflation closer to 3%.

That said, the Fed’s interest rate decisions are still influenced by this target, and there’s little reason to believe that will change anytime soon.

Powell manages expectations

The Fed’s plan to lower interest rates was partially derailed earlier this year due to an uptick in inflation—thanks in large part to rising energy and shelter costs, as well as sticky service inflation.

But despite the inflation scare, Fed Chairman Jerome Powell stuck to his guns, remaining confident that cost pressures would eventually come down.

According to economists, Powell still holds a “glass half full” view about inflation unless something drastically changes.

Tony Welch, chief investment officer at SignatureFD, agrees with Powell’s approach. He thinks that soaring energy prices have distorted the inflation outlook.

“I’m pretty confident that [the Fed is] right and they’re reading the inflation tea leaves correctly,” he told Reuters.

But others aren’t taking the Fed chair at face value.

“Powell can say whatever he wants, but ultimately the inflation numbers will dictate what happens,” Neil Dutta, head of economic research at Renaissance Macro Research, told The Wall Street Journal.

“If they just don’t make further progress on inflation, it will be right at some point to say, ‘We don’t know what direction rates are going to go,’” according to William English, a former Fed adviser and current professor at Yale School of Management.

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