The Fed's rate hike policy doesn't have many fans — but abandoning the inflation target would be a 'disaster' that brings the economy back to the 1970s, a Fed official says

• The president of the St. Louis Fed said it would be a disaster for the Fed to abandon its inflation target.
• The Fed has been hiking interest rates aggressively to get inflation down to 2%.
• But the hikes are stoking concerns that the economy could cool so much that it tips into a recession.

A Fed official said it would be "a disaster" to abandon the central bank's 2% inflation target, amid widespread blowback that an aggressive rate hike cycle could slow the economy too much.

"We do have a mandate legislated by Congress and the President to maintain stable prices for the US economy. That's in the law," James Bullard, the president of the Federal Reserve Bank of St. Louis, said after a presentation to Greater St. Louis Inc. "We've defined stable prices as 2% inflation. That's an international standard that was developed in the 1990s. I think it would be a disaster to abandon that standard."

Bullard even cautioned "we would be back to the 1970s" if the Fed gives up on its fight against inflation.

He was referring to a period of high inflation that peaked at nearly 15% in March 1980. The price shocks were due to several factors — such as the Oil Crisis of 1973 and the Vietnam War. The Fed then targeted inflation aggressively and adopted the 2% inflation target in the 1990s.

The US central bank explains on its website that the 2% inflation target over the long run is most consistent with its mandate for "maximum employment and price stability."

Inflation — as measured by the personal consumption expenditures — hit 5.4% in January, well above the 2% target, spurring the Fed to hike its benchmark interest rates to 4.75% to 5% for the ninth straight time last week.

Bullard's comments echo those of former Treasury Secretary Larry Summers, who in January said the economy could be hit with 1970s-style inflation if the Fed abandons its 2% inflation target.

"To suppose that some kind of relenting on an inflation target will be a salvation would be a costly error, it would ultimately have an adverse effect as it did in a spectacular way during the 1970s," Summers said at the World Economic Forum.

The Fed is also sticking with its messaging of getting inflation down to 2%. "We are committed to restoring price stability and all of the evidence says that the public has confidence that we will do so, that we'll bring inflation down to 2% over time," Fed chair Jerome Power said at a press conference last Wednesday, according to a transcript.

Not everyone's sold on the idea.

But not everyone's in agreement with the Fed. 

Economists such as Mohamed El-Erian and billionaire investor Bill Ackman have argued that the US should move the inflation target upward to avoid slowing down the economy too much.

Ethan Harris, a Bank of America economist, wrote in a December note there's little evidence that the 2% inflation target is the "optimal target," per Fortune. "The evidence is that steady 4% inflation imposes very small additional costs compared to steady 2% inflation. Either way, the economy adapts," Harris added.

Ann Pettifor, a leading economist who correctly predicted the Global Financial Crisis back in 2006, also criticized central banks for waging a "class war" in their pursuit to crush inflation with higher interest rates.

The Fed is focussing on 'supercore inflation.'

The criticisms come amid stubbornly high inflation, despite the Fed's relentless rate hikes.

The US personal consumption expenditures rate rose to 5.4% in January — that's slightly higher than 5.3% in December, but still lower than the 5.6% and 6.1% in November and October, respectively.

Most of the decline came from falling energy prices Bullard said, "so you don't want to live and die on international commodity markets."

That's why the Fed is closely tracking supercore inflation — which excludes volatile food, energy, and housing prices to get a better handle on the situation. 

Higher interest rates make borrowing — like mortgages to credit cards more expensive. And it encourages people to save rather than spend, which in theory, helps bring down prices. But it takes a while for the effects to be felt and the risk is that the central bank raises rates to the point where the economy slows down and even tilts into recession, as demand contracts.