Both the US Federal Reserve and the European Central Bank appear to be dead set on getting inflation back to their 2% target. But while 2% is viewed as a kind of “sweet spot” for inflation – neither so high that consumers struggle to cope, nor so low that it stifles economic dynamism – it is ultimately arbitrary, and its primacy in monetary policymaking is a relatively recent phenomenon.
Winston Churchill famously quipped that “democracy is the worst form of government except for all the other forms that have been tried.”The same logic applies to advanced-economy central banks’ inflation targets: compared to anything higher or lower (by a non-trivial margin), 2% is likely to be better.
A comprehensive assessment of the proper target would require us to answer a number of questions. One would be: How accurate are inflation measures? Despite important improvements in measuring inflation, an upward bias of a bit less than one percentage point remains, owing primarily to incomplete and lagging quality-change and new-product adjustments. So, when inflation measures show 2%, actual inflation is roughly 1%. When they show 4%, actual inflation is 3%. So, raising the as-measured inflation target from 2% to 4% triples the actual inflation target.
Second, we must ask what the optimum inflation rate is. In analyzing this question, economic luminaries – including Knut Wicksell, Milton Friedman, Robert Mundell, James Tobin, and Edmund S. Phelps – have come up with different measures of the “inflation tax” and reached different conclusions about the optimal relationship between Treasury deficit policy and monetary policy. Friedman argued for deflation and inflation at different points in his career.
More recent models illuminate the tradeoffs, but basic questions remain, related to the substitutability of bonds and money, the relevant conditions (for example, if there is an upper limit on the private sector’s willingness to hold bonds), and the relative cost of other distortionary taxes. We must consider the likely costs of a higher inflation target for the real economy, incurred, for example, through higher variance in relative prices or higher taxation of capital which is not inflation-indexed and where the tax distortion increases exponentially over time.
A third question is: Is a stable inflation rate preferable to one that varies significantly, at least within some modest range?If so, we must ask whether central banks can realistically keep a higher inflation rate relatively stable.
Fourth, we must ask whether a higher target is compatible with a rules-based monetary-policy approach pursued (by the Fed) under a dual mandate that includes maximum employment. To what extent would this amount to the abandonment of price stability, and could the likely fallout be contained? Once the 2% target was abandoned, could it be adopted anew, or would the monetary authorities have lost too much credibility?
Finally, we must consider whether a higher target would discourage elected officials from exercising fiscal discipline – an area where they are already falling far short. It is also worth remembering that President Richard Nixon imposed wage and price controls on the American economy when inflation got up to 4%. All things considered, sticking with 2% seems to be by far the best option.
No, 2% is not the right target. Central banks and governments should target the price level. That means not just pursuing 0% inflation, but also, when inflation or deflation unexpectedly raise or lower the price level, gently bringing the price level back to its target. (I say “and governments” because inflation control depends on fiscal policy, too.)
The price level measures the value of money. We don’t shorten the meter 2% every year. Confidence in the long-run price level streamlines much economic, financial, and monetary activity. The corresponding low interest rates allow companies and banks to stay awash in liquidity at low cost. A commitment to repay debt without inflation also makes government borrowing easier in times of war, recession, or crisis.
Central banks and governments missed a golden opportunity in the zero-bound era. They should have embraced declining inflation, moved slowly to a zero-inflation target, and then moved gently to a price-level target.
Why not? Some focus on the short run and say that central banks should raise the inflation target, because getting inflation to 2% will require too much pain in the form of unemployment. But inflation is falling alongside very low unemployment, proving this argument wrong again. And shifting the goal posts undermines the stable expectations that allow relatively painless disinflation.
The other argument says that a higher inflation target creates more room to use rate cuts to stimulate the economy in times of recession. But that is like wearing shoes that are too tight all day, because it feels so good to take them off at night. This argument presumes that expected inflation is set mechanically by previous experience. Moreover, the evidence that slightly lower overnight rates provide much stimulus is weak. The potential benefit is not worth permanently abandoning a stable value of money.
Empirical evidence suggests that the 2% inflation target is indeed arbitrary. When I first reviewed that evidence a decade ago for my book Remembering Inflation, I concluded that variations in the inflation rate of up to around 5% have no material effect whatsoever, either positive or negative, on rates of real economic growth, especially if the inflation rate isn’t too volatile. Since then, I have seen no new research that would cast doubt on this conclusion.
Moving from the general to the particular – that is, the present situation – it would be counterproductive to persist with monetary tightening until the consumer price index falls to 2%. This would mean further compression of real household incomes, which have been stagnating or declining, on average, for the past decade, and heightening the risk of social and political disruptions.
The result would be more macroeconomic volatility, especially if aggressive monetary tightening also triggered renewed bank failures or wider financial instability, as seen earlier this year. Conversely, a recovery in real average wages, alongside higher-than-2% inflation, would provide a much-needed boost to productivity, as it would motivate workers, particularly in the health-care and education sectors, and create incentives for more labor-substituting investment.
Domestic investment demand will, in any case, grow in response to climate-related concerns and the ebbing of the globalization tide. In this new economic environment, average inflation should naturally be somewhat higher than it has been in recent decades. Under these circumstances, central banks’ doctrinaire insistence on driving inflation down to 2% is harmful.
There is certainly nothing magical about 2%, although as Stanley Fischer has argued, it is low enough that the public doesn’t feel the need to think about inflation. There are two obvious arguments for a higher inflation target – one convincing, one not so much. The convincing argument stems from the fact that it is very difficult for firms to cut nominal wages. Having a higher inflation target allows for more room for relative wages to change, especially within a firm.
The less convincing argument is that there is an immutable zero lower bound on nominal interest rates. In fact, it would be relatively easy and straightforward to implement an effective negative nominal-interest-rate policy. It would of course require various tax, institutional, and legal changes, but none terribly radical. Indeed, merely having the inflation rate 1-2% higher would not be nearly enough to deal with major adverse shocks that require interest-rate cuts of at least 5-6%, and perhaps more. The only real challenge is how to pay a negative interest rate on large cash currency holdings, but this, too, is easily solved – for example, by phasing out large-denomination currency notes and by relaxing the one-to-one exchange rate between the digital- and paper-currency dollar.
In any case, any argument for raising central-bank inflation targets to, say, 3% or 4%, is trumped by the fact that 2% targets have been in place for decades. Any effort to change the target would inevitably lead to a period of sustained policy uncertainty, not to mention confusion over whether the target might be opportunistically raised again in the future.
With the overwhelming dominance of digital currency rapidly approaching, the energy it would take to raise the inflation target would be better directed toward highlighting the fact that allowing for occasional negative short-term rates would enable central banks to maintain low inflation, something that is very popular with the public.
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