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The Ahistorical Federal Reserve

The most effective – and thus the most credible – monetary policy is one that reflects not only the lessons of history, but also a willingness to reconsider long-held assumptions. Unfortunately, neither attribute is much in evidence at today's Federal Reserve.

BERKELEY – Economic developments over the past 20 years have taught – or ought to have taught – the US Federal Reserve four lessons. Yet the Fed’s current policy posture raises the question of whether it has internalized any of them.

The first lesson is that, at least as long as the current interest-rate configuration is sustained, the proper inflation target for the Fed should be 4% per year, rather than 2%. A higher target is essential in order to have enough room to make the cuts in short-term safe nominal interest rates of five percentage points or more that are usually called for to cushion the effects of a recession when it hits the economy.

The Fed protests that to change its inflation target even once would erode the credibility of its commitment to ensuring price stability. But the Fed can pay now or it can pay later. After all, what good is credibility today when it means sticking tenaciously to a policy that deprives you of the ability to do your job properly tomorrow?