People the world over have been facing a poisonous new economic reality, as inflation has emerged from multi-decade hibernation.  And many of the people dealing with it are too young to remember when inflation was last a serious issue.  It is economically damaging, socially corrosive, and very hard to bring down.

Both the U.S. Federal Reserve (Fed) and the European Central Bank appear dead set on getting inflation back to their 2 percent target. Why did these and other banks, such as the Bank of Canada, Sweden’s Riksbank, and the Bank of England gravitate to this 2 percent figure?

In January 2012, a thousand years ago in internet time, the Fed, under Chairman Ben Bernanke, formally adopted an explicit inflation target of 2 percent. This marked the first time the Fed ever officially established a specific numerical inflation target. The 2 percent target was seen as a way to provide clarity and enhance the effectiveness of monetary policy.

Bernanke’s successor Janet Yellen and current chair Jerome Powell maintained the 2 percent inflation target. While Powell has a laser focus on the 2 percent target, the Fed has recently moved to a more flexible 2 percent average over time. This means the Fed would tolerate some periods of inflation above 2 percent to offset periods when inflation was below that level.

The 2 percent target was not established based on any specific formula or fixed economic rule. Despite its widespread adoption by central banks, there is little empirical evidence to suggest that 2 percent is the platonic ideal for addressing the Fed’s dual mandate of price stability and maximum employment.

This inflation target is an arbitrary number that originated in New Zealand. Surprisingly, it came not from any academic study, but rather from an offhand comment during a television interview.

During the late 1980s, New Zealand was going through a period of high inflation and inability to achieve stable economic growth – the financial equivalent of a bloody nose.  In 1988, inflation had just come down from a high of 15 percent to around 10 percent. New Zealand’s finance minister, Roger Douglas, went on TV to talk about the government’s approach to monetary policy.

He was pressed during the interview about whether the government was satisfied with the new inflation rate.  Douglas replied that he was not, saying that he ideally wanted inflation between zero and 2 percent.  This involved targeting inflation, a method that had kicked around in economic literature for years but had not been implemented anywhere.

At the time there was no set target for inflation in New Zealand; Douglas’ remark was completely off the cuff. But the inflation target caught the attention of economists around the world and went viral, becoming a kind of orthodoxy.  The approach gained recognition and as noted, was subsequently adopted by many other central banks, making inflation targeting a widely used monetary policy strategy – a classic example of how ideas spread within the small priesthood of central bankers.

The hard truth is that many economic luminaries have tried to come up with what is thought to be the optimum inflation rate, but with little success.

All things considered the 2 percent target was seen as a kind of sweet spot for inflation despite the lack of serious intellectual groundwork. Simply stated, there is nothing magical about 2 percent.  It is low enough that the public doesn’t feel the need to think about inflation, but not so low as to stifle economic growth.  That’s how it goes, but not so much more.

Interest rates play a crucial role in the economy, influencing savings, investment, consumption and overall growth.  Central banks around the world cut benchmark interest rates sharply following the 2007-09 financial meltdown that  tanked the global financial system. In many cases, the nominal interest rate was cut to zero, close to zero or even negative territory.

It was thought that these aggressively low interest rates helped stimulate economic activity, although there remain uncertainties about the side effects and risks. 

Distressed, or “Zombie,” companies feasted on cheap credit. These firms tied up resources that could have been better allocated to more productive and efficient businesses, hindering overall economic growth.

For example, companies such as Bed Bath & Beyond earned just enough money to continue operating, but were unable to pay off their debts as interest rates rose.  As rates have risen, many of the loans banks made to these firms have turned out to be stinkers, as borrowers miss payments or default. 

Indeed, cheap credit, by way of low interest rates, was allowed to persist for an improbable 14 years – much too long in the minds of many analysts.  What was initially seen as a blessing turned out to be a curse. 

When continued for too long, cheap credit effectively inspires excessive borrowing – some of it speculative.  And bubbles do eventually burst. 

A lot has happened since the 2007-09 financial crisis. Recently, inflation has returned with a vengeance.  The Federal Reserve and other central bankers are trying to stop surging prices by raising short-term interest rates, which is not necessarily a boom for the stock market or the economy.

Rising interest rates help control demand for credit, soften growth of the money supply and therefore help control demand.  In theory, higher mortgage rates may slow housing price inflation and help make property more affordable over time. 

Others argue that today’s rate hikes threaten to push up tomorrow’s housing costs amid high prices for materials and loans.  This creates a threat of future housing shortages that could lead to more inflation.

High interest rates prevent a misallocation of capital goosing the price of the riskiest assets in the shares casino.  Then there are investment projects, often vanity projects, that only proceed because of cheap capital. 

As interest rates rise, they incentivize savings in contrast to the recent near-zero interest rates that made savers – including many retirees – feel like fools.  

Finally, high interest rates give central banks room to cut interest rates in the event of a negative external shock. In sum, they act as a deterrent to excessive borrowing and spending, curbing inflationary pressure and preventing the formation of bubbles.

But higher interest rates also bring with them the risk of significant slowdowns in consumption.  They might choke off much needed business investment in new home building and renewable energy capacity, for example. 

Rising interest rates may cause the dollar to appreciate, making exports less competitive and leading to an export slowdown and perhaps a worsening trade deficit.

Higher interest rates certainly make government debt more expensive, sending debt costs soaring and eating up a bigger share of public budgets.

Finally, higher interest rates might lead to a broad-based economic slowdown that could hit stock prices, pension fund assets, and dividend incomes.

In recent months, inflation has been as persistent as gravity.  A cold dish of truth is that it is unclear when prices will moderate.  The Fed took a break from raising interest rates at its June meeting after a string of 10 consecutive rate hikes in just over a year. Still, the benchmark rate could go a bit higher in the near future.  

The Fed is taking some time to assess the effects of its prior rate hikes on inflation and the overall economy, as well as the impact of other economic activity – namely the collapse of three banks this spring.  Improvisation is clearly the order of the day.

One definition of intellectual dishonesty is the practice of ignoring reality when it interferes with what you want to believe about the way the world works.  The bipartisan deal President Biden signed on June 3, after months of political brinkmanship to raise the debt limit for two years and increase the amount of money the federal government can borrow, is an example.

Cynics might be forgiven for insisting there is a great deal to be said for intellectual dishonesty in American society.  They would remind us that the body politic is much more likely to enjoy an adequate supply of the public goods and services that are so vital to the national welfare if Americans can convince themselves that “someone else” is paying for them.

Whenever we admit to ourselves that the cost is coming out of our pockets, we inevitably try to cut corners or do things on the cheap, and ultimately deprive ourselves of much that is really needed.

Many Americans would argue that government has played a major role in this national con game since the early days of the republic.  By cleverly manipulating things like tax rates, deductions, and public accounting practices, the government has made it easy for Americans to persuade themselves that “the other guy” is paying most of the bill for the things we need.  All of which has helped make the United States great—in the sense of becoming the world’s most ostensibly successful national economy for the moment.

The national debt has soared, nearly tripling since 2009, forcing the U.S. Treasury Department to borrow more to pay for government spending.  The legislative curb on this borrowing is known as the debt ceiling.  When Treasury spends the maximum amount authorized under the ceiling, Congress must vote to suspend or raise the limit on borrowing.

The latest deal includes caps on federal spending, additional work requirements for food stamps and welfare, and reforms to build energy projects more quickly.  But the caps would not actually reduce spending.  The end game is to make it grow more slowly, say more slowly than the rate of inflation.

Divided government is never pretty.  But if you are of a Panglossian persuasion, you will rejoice that this deal enables both sides to claim a win of sorts.

Neither wants to be responsible for a catastrophe, so each pretends it is a win-win deal. Republicans can say they cut spending since spending will grow more slowly than it might have otherwise. Democrats can argue that they prevented actual cuts.  In theory, everyone wins and politicians insist they conducted themselves in an intellectually honest fashion.

But the American public, not elected officials and government bureaucrats, is to blame for this.  They insist on receiving more from government than they’re willing to pay for, and they don’t ask any serious questions about the charades and fiscal shenanigans necessary to sustain the illusion of a free lunch.

The U.S. is up to its neck in debt – $31.4 trillion as of January 2023.  Since it cannot increase its income in the short term, it needs to exchange new debt for old debt, leaving no choice but to raise the debt ceiling to avoid global economic chaos.  The annual federal deficit has averaged nearly $1 trillion since 2001, meaning government spends that much more money than it receives in taxes and other revenue.

To make up the difference, the government has to borrow to finance payments that Congress has already authorized. Even with the debt limit raised, the best way to repay the debt is to figure out how to revive the economy.

Good government types and fiscal moralists may be outraged by these shell games and urge Americans to stop acting like children.  But Americans have a long and pragmatic tradition of believing that fiscal morality, like religion and the law, is great as long as it doesn’t get in the way of anything really important.

So, things really are different this time.  The Federal Reserve Bank decided to raise its Federal Funds Rate on May 3 by a quarter-point, to 5.00-5.25 percent, in spite of a banking crisis that has seen three large banks fail in the space of six weeks, with remarkably little spillover into the economy at large. The misery mostly limited to shareholders in the banks concerned.   This is where rates sat before the financial crisis hit in 2008.

This recent rate hike has caused plenty of controversy as fears grow that further hikes risk tipping the economy into recession.  The inflation rate sat at 5 percent on the year in March, but core inflation (which excludes fuel and food) slightly increased in March, up to 5.6 percent. So, the Fed raised rates once again, in an effort to get price hikes under control, reiterating their focus on dragging inflation back down to earth even if it means tipping the economy into recession.

It should be noted that unemployment fell to 3.4 percent last month, matching the lowest reading since 1969.  So far, historically high inflation, slowed economic growth, increasing interest rates and banking turmoil has not cracked the still hot labor market.

For the past two decades, this sort of thing didn’t happen.  Under the unwritten laws of the “Greenspan put”, the Fed could be relied upon to provide some form of stimulus at the first sign of financial trouble.  It began with the collapse of the hedge fund Long Term Capital Management in 1998, when the Fed put together a $3.6 billion bailout funded by a consortium of banks, and it carried on long after former Fed chair Alan Greenspan himself had departed the scene.

Greenspan argued with monotony that “free markets are inherently self-regulating”, (like foxes are inherently the best guardians of chickens).  If markets wobbled, if banks got into a spot of trouble, an interest rate cut, or quantitative easing was never far behind.  He took the Fed in a direction quite different from the previous ruling guideline expressed by William McChesney Martin, Fed Chairman from 1951 to 1970, who’s famous for supposedly having said: “The Fed’s job is to take the punch bowl away just when the party’s going good”.  Or words to that effect.

Investors formed an expectation that the Fed would always help.  It was an Alice in Wonderland world where bad economic news often became good—good because investors calculated that the Fed would respond with a stimulus package.  By such means, the country ended up with the bubble economy of the past 20 years.

But this time around, the Fed has failed to oblige.  True, until the collapse of the Silicon Valley Bank, the Fed had been expected to raise rates by half a percentage point compared with the quarter point increase announced May 3.  But by raising rates at all the Fed has signaled that yes, it really did mean it when it said it was going to tackle inflation.  Not even falling US inflation has persuaded the Fed to take a break from its tightening program.  The Fed officials have said they want to see sustained evidence that inflation is moving toward their 2 percent goal.

The Fed finds itself in a tricky situation, having failed to act on price rises early on, so now they are playing catch up.  They were too late to the game to keep prices under control—having suffered a hit to credibility, have had to keep hiking rates, putting a damper on economic growth.  The Fed is clearly hoping this is the end of the line.

It softened its language in its statement after the May 3 hike, no longer preparing investors for further rate hikes, but rather noting that a myriad of factors—including economic growth—would feature in the “extent to which additional policy firming may be appropriate”.  In other words, interest rates may still rise, but it is by no means certain.  Ergo, only a naïve or ignorant person who say the worst if over.

The past two and a half years have been extraordinary.  The unnerving combination of a global pandemic exacerbated by energy scarcity, supply chain disruptions, the return of inflation,  rising multipolar geopolitical tensions, and a new monetary era have people wondering what certainties are left. Still, in times of rapid change, it’s nice to know that some things stay the same.

Take The Federal Reserve for an example.  The Fed does not learn from its mistakes.  The Fed lost control of the money supply, causing inflation to soar.  In the two years following the March 2020 COVID-induced recession, the Fed allowed the broad money supply to expand by a staggering 40%.

It did so by keeping its policy rate at its zero-lower bound and increasing the size of its balance sheet by almost $5 trillion through its aggressive purchases of Treasury bonds and mortgage-backed securities.

In 2021, not hemming and hawing, the Fed kept assuring the American public that the inflation they were experiencing was a transitory phenomenon.  The Fed lost much credibility by failing to acknowledge inflation was surging back in 2021 and it is not obvious it has rebuilt its reputation.  This despite warnings that the explosion in money supply growth would take the country back to the inflation of the 1970s.

Not to forget, the Fed effectively pursued a policy of zilch interest rates or free money for 14 years since the 2008 financial crisis.  Individuals and institutions happily adapted to a universe in which money was practically free.  They forgot that free money turns out to be expensive. By failing to return the price of credit to something normal the Fed was fueling greater risk taking.

A sign of an intelligent mind is learning from one’s mistakes.  This is not the case with the Fed. The technocrats, the boffins, and the cognitive elites didn’t know what they were doing. Worse than not knowing what they were doing, Americans suffered big declines in disposable incomes over long period as a result of their policy choices. The economy did not deliver to the great majority of Americans the sort of life they wanted and hoped for.

People bought houses they could only afford with tiny interest payments, companies borrowed to buy back their own shares, investors borrowed to buy stock in a can’t lose stock market, and politicians ran up national debts whose servicing was only possible if interest rates remained negligible forever, putting the country on an unsustainable fiscal trajectory.

Then in 2022, the wise men at the Fed started raising interest rates at the fastest pace in half a century: 500 basis points in pursuit of lower inflation.  That is a lot to cram through the economy in a year and something just might break. And it did.  March madness was the appropriate tag line applied to last month’s scare provoked by the collapse of three U.S. banks as a result of rate hikes poor management, and the abject failure of regulators.

Of course, none of this would have been necessary had the Fed started tightening monetary policy a year earlier. The inflation was not transitory. It’s a bitter solace to savers that they can earn a meager say, 4.5 percent interest on their savings only now that, inflation being so high, that their funds on an inflation adjusted basis are still losing value and adding to the cost of living crisis for the ordinary American.

Ushering back in a new era of cheap money is by no means a requirement but would be a tempting one at that given how addicted to mass spending everyone has become.  But that if the Fed has learned anything would have serious repercussions.

Looking forward it may well be that in God’s newly automated earth, AI will offer a precious escape from the problem of setting interest rates, avoiding the friction and stress and politics which accompanies developing monetary policy.  Just as the intelligent ChatGPT is churning out poetry better than Milton,  surely this new technology can design, plan, and execute monetary policy in the future.   They are becoming quite good at that.