What the Fed Really Wants Is to Lower Real Wages
To achieve economic growth over time, prices have to change in order to adjust resource allocation to changing circumstances. This includes the price of work, or wages. Everybody does or should know this, and the Federal Reserve definitely knows it.
The classic argument for why central banks should create inflation as needed is that this causes real wages to fall, thus allowing the necessary downward adjustment, even while nominal wages don't fall. Specifically, the argument goes like this: For employment and growth, wages sometimes have to adjust downward; people and politicians don't like to have nominal wages fall-- they are "sticky." People are subject to Money Illusion and they don't think in inflation-adjusted terms. Therefore create inflation to make real wages fall.
In an instructive meeting of the Federal Reserve Open Market Committee in July, 1996, the transcript of which has been released, the Fed took up the issue of "long-term inflation goals." Promoting the cause of what ultimately became the Fed's goal of 2% inflation forever, then-Fed Governor Janet Yellen made exactly the classic argument. "To my mind," she said, "the most important argument for some low inflation rate is...that a little inflation lowers unemployment by facilitating adjustments in relative pay"-in other words, by lowering real wages. This reflects "a world where individuals deeply dislike nominal pay cuts," she continued. "I think we are dealing here with a very deep-rooted property of the human psyche"-that is, Money Illusion.
In sum, since "workers resist and firms are unwilling to impose nominal pay cuts," the Fed has to be able to reduce real wages instead by inflation.
But somehow the Fed never mentions that this is what it does. It apparently considers it a secret too deep for voters and members of Congress to understand. Perhaps it would be bad PR?
This classic argument for inflation is of course a very old one. As Ludwig von Mises discussed clearly in 1949, the first reason for "the engineering of inflation" is: "To preserve the height of nominal wage rates...while real wage rates should rather sink." But, he added pointedly, "neither the governments nor the literary champions of their policy were frank enough to admit openly that one of the main purposes of devaluation was a reduction in the height of real wage rates." The current Fed is not frank enough to admit this fact either. Indeed, said von Mises, "they were anxious not to mention" this. So is the current Fed.
Nonetheless, the Fed feels it can pontificate on "inequality" and how real middle class incomes are not rising. Sure enough, with nominal wages going up 2% a year, if the Fed achieves its wish for 2% inflation, then indeed real wages will be flat. But Federal Reserve discussions of why they are flat at the very least can be described as disingenuous.
Meanwhile, earlier this year across the Atlantic Ocean, the Governor of the Bank of England, Mark Carney, was pleased to highlight that since inflation had been on the low side, real wages had gone up. As paraphrased by the Financial Times: "Price falls are a bonus, having given workers their first real terms pay rise in years." This expressed an accurate relationship. Having cited it, however, the editors of the Financial Times perversely hoped that inflation would go back up "to target." Do they know "the most important argument" for having that inflation target?
In the United States, the Federal Reserve Act instructs the Fed to seek "stable prices." The Fed has worked hard to avoid this assignment, redefine the plain language of the statute, and convince people that "price stability" really means 2% inflation forever. It is time for the Fed to talk as frankly to its boss, the Congress, as frankly as it talked to itself, about why it wants, and how it intends to use inflation, to reduce real wages as needed.