After eight years, the Federal Reserve is finally admitting that it might need to change what it's doing. Although that might not be enough if also it doesn't change how it's doing that.
I'm talking, of course, about the Fed's inflation target. Right now, that's 2 percent. But a group of liberal economists — including Nobel Prize-winner Joseph Stiglitz, former Minneapolis Fed chief Narayana Kocherlakota, and former head of the Council of Economic Advisers Jason Furman — think that might be as much as 2 percent too low.
And Fed Chair Janet L. Yellen isn't ruling that out. “We will be reconsidering at some future time,” she said in her news conference on Wednesday, whether they need to increase their inflation target. Going forward, she expects this will be “one of the most important questions facing monetary policy around the world.”
What's the problem with the 2 percent target? Well, it hasn't done what it was supposed to. The whole idea, you see, was that it was low, but not so low that the economy would ever get stuck in a slump. That, at least, is what a then-Fed Governor named Janet L. Yellen argued back in 1996 when she managed to convince her colleagues that it was better to target a small amount of inflation rather than none at all. They thought there would be three big benefits. The first was that unemployment would be a little lower since companies could let inflation effectively cut people's wages instead of having to fire them to do so. The second was that more inflation would let the Fed push inflation-adjusted interest rates down even further when the economy needed the help. And the third was that it would allegedly keep interest rates from falling to zero. Fed economists, to be exact, thought that would only happen 5 percent of the time with a 2 percent target. The reason, of course, that they cared so much about avoiding that situation, one the United States hadn't seen since the 1930s, was that it made stimulating the economy harder just when the economy needed stimulus the most.
Now, that last part was obviously incorrect in a world where interest rates were just zero for seven years and look like they will be again every time there's a recession. But more to the point, the Fed would obviously prefer for rates not to be stuck at zero for 35 to 40 percent of the time. Put those together, and you can see why the Fed is at least thinking about a higher inflation target.
All of this is to say that the logic behind a 2 percent target wasn't wrong. The math was.
Think about it like this. The higher inflation is, the higher interest rates have to be to control it — and the more room there is to cut them when the economy gets into trouble. So if a 2 percent target doesn't get rates high enough to keep them away from zero, then maybe a 4 percent one will.
But even if it did that, the Fed would still have one big problem. That's the way it approaches any kind of inflation target. Here's what I mean by that. The Fed says that it's just as willing to let inflation go slightly above its 2 percent target as it is for it to go slightly below it, but there's no reason to actually believe that. After all, the Fed is projecting that inflation is going to stay below 2 percent for the rest of 2017, just like it was in 2016 and 2015 and 2014 and 2013 and 2012. This isn't an accident. Not when the Fed just raised rates in the face of falling inflation. That's right: even though inflation has been slipping and job growth has too, the Fed is so focused on the risk that prices might start rising faster that it just increased interest rates. Why? Well, despite the fact that lower unemployment hasn't translated into higher inflation so far, the Fed is worried that it will at some point. And so rather than having to play catch-up and hike rates so fast that it pushes the economy into a recession, it's trying to space those out even when they don't seem necessary — like now.
As far as risk management goes, this isn't crazy. But that's only if you assume that inflation going over 2 percent is such an urgent problem that you'd have to raise rates over and over and over again to fix it. You don't have to. The Fed could treat this the same way it does below-target inflation: as something it wants to change, but will put up with for now. The counterintuitive thing about that is not raising rates like this would probably lead you to raising rates more in the long run. That's because hiking too much too soon tends to make it so you don't need to hike too much at all. As Japan or Sweden or any other country that's tried to raise rates from zero like this could tell you, you'll have to turn around and start cutting rates again in no time.
So if the Fed wants to get back to a world where interest rates don't spend a lot of time at zero, it will need to not only try to get more inflation, but also be comfortable with the inflation it does get.
There are worse things than 2 percent inflation.