People often stop me on the street and say, “Hey, nerd … why is the Federal Reserve’s inflation target 2 percent?”
Good question. Here’s the Fed’s own answer:
The Federal Open Market Committee (FOMC) judges that inflation at the rate of 2 percent (as measured by the annual change in the price index for personal consumption expenditures, or PCE) is most consistent over the longer run with the Federal Reserve’s mandate for price stability and maximum employment. Over time, a higher inflation rate would reduce the public’s ability to make accurate longer-term economic and financial decisions. On the other hand, a lower inflation rate would be associated with an elevated probability of falling into deflation, which means prices and perhaps wages, on average, are falling–a phenomenon associated with very weak economic conditions. Having at least a small level of inflation makes it less likely that the economy will experience harmful deflation if economic conditions weaken. The FOMC implements monetary policy to help maintain an inflation rate of 2 percent over the medium term.
That doesn’t really sound right to me or economist Larry Ball, who points out the advantages of a 4 percent target, most notably, insurance against hitting the zero lower bound (ZLB: the very serious problem that occurs when the Fed’s main tool — the interest rate it controls — is zero and thus cannot be lowered further even if economic conditions warrant further lowering; if that sounds far-fetched, it’s in fact precisely where we’ve been stuck for years now).
The confusion in the Fed’s statement is the conflation of the level of inflation with its trend. That is, if the public expects inflation to stay pretty much where it is, i.e., if inflationary expectations are “well-anchored,” then it’s not clear why the “public’s ability to make accurate … etc.” would be fine at a 2 percent anchor, but a problem at a 4 percent anchor.
True, history shows there’s more variance (i.e., jumpiness) around the path of inflation when it’s higher, but that’s pretty much automatic — regression to the mean: When a variable is higher than usual, it’s likely to drop back to something closer to its mean level. Again, the key is where the Fed sets the anchor, and 2 percent is but one plausible choice.
I vaguely remember some other explanation: The central bankers who first decided on 2 percent, which is a common target throughout advanced economies, believed that the measured inflation rate was biased up by something like this amount. So they were really trying to set the target rate at zero. If so, that sounds like a great way to tempt the ZLB, deflation and high real interest rates.
The fact is that the target is 2 percent because the target is 2 percent. Were the target 3 percent or 4 percent, you’d be reasonably asking me, why 3 or 4? To the extent that there’s an anti-inflation bias among economic elites (and thus an anti-full-employment bias), and I think that’s often the case, I’d reiterate arguments I made here.
I spent the day Wednesday at a great conference on measuring slack in the economy with some of the top flight folks in the business. And these analysts were not just smart, but honest. It was widely admitted that these days we don’t have much of a handle of the relationship between slack and price dynamics (technically: the current dynamics of the Phillips curve, which plots the relationship between inflation and unemployment, are poorly understood, but it is widely judged to be flat right now, such that feedback from labor market slack to inflation is historically low).
In that regard, I’d argue, as did Chicago Fed President Evans on Wednesday (brilliantly, I thought). In the face of a) our limited understanding of the dynamics in play, b) a Fed with strong anchoring instincts and a huge armory of anti-inflation ordinance (lots of room to move rates up and a $4 trillion balance sheet to unwind), and c) asymmetric risks: the current risks of whacking the recovery appear far greater than the risks of spiraling inflation, the right move in terms of tightening is patience … a lot of patience.