2%.
The 2% inflation target is key to the Fed's vision for
stable prices in the US economy, as well as the rest
of the world.
2% Bank of England Inflation target.
But who decided 2% was the magic number?
It is, I think, an error to say 2% is somehow magically
the right number.
You would think somewhere in the Bible, God says he wants
2% inflation.
The 2% inflation target like it's relatively arbitrary.
It was invented oddly enough, in New Zealand.
25, 30 other central banks adopted the New Zealand
approach. So, we led the way in inflation targeting.
I mean, there's a bit of a mafia amongst central
bankers. You know, once you're in the family, you're
in the family sort of things, and they all get
together, sit around conference tables.
Turns out the 2% inflation target didn't exactly start
that way.
It's sort of a historical accident.
Somehow it just became 2%.
Okay,2% Good.
Yeah. They missed out the zero, Two.
0 to 2.
Here's how economies across the globe adopted inflation
targeting, how they settled on 2% and whether or not
that target may change.
The Federal Reserve uses monetary policies to achieve
its dual mandate.
Maximum employment and price stability.
Price stability can be achieved with inflation
targeting, which is.
Just the simple idea that the way a central bank
should run its policy is to choose an explicit numerical
target for inflation.
The Federal Reserve didn't have an official inflation
target until 2012, which happened to be right after
the Federal Open Market Committee contrarian of the
time, Tom Hoenig, left his position.
I was president of the Federal Reserve Bank of
Kansas City from 1991 to 2011.
During the period that I was there, it followed the
great inflation.
That period was really quite chaotic, if you will.
And too many dollars start, chasing too few
goods.The result?
Inflation. In the late eighties, an individual from
the Bank of New Zealand came to the United States.
That individual is Arthur Grimes.
He is pretty much the father of inflation
targeting.
The seventies and eighties, New Zealand had one of the
highest inflation rates in the Western world.
Grimes was fresh out of the London School of Economics.
I applied these new insights into designing a brand new
central bank act. It was a wonderful opportunity for a
for a really freshly minted PhD economist.
I had worked at the bank for six years before I did
my PhD, so I knew the central bank well.
So the bank was shifting to be more independent because
in New Zealand, at the time, its central bank was
tied to the government.
We were saying, 'Okay, if we have independence, what
should we target? Interest rates or the money supply?'
One day I said, 'Well, actually what are we trying
to achieve? We're trying to achieve price stability.
Why don't we just have an inflation target?' You know,
it's sort of like cut through the middleman.
And thus inflation targeting was born not as a strict 2%,
but instead as a range.
But we really wanted to embed our credibility by
achieving a target that no one believed we would
achieve. So we made the target pretty tight, just 1%
plus or -1%, which became just the 0 to 2.
And I have to tell you, even around the table at the
central bank, we didn't believe it.
Know the idea of achieving 1% inflation was none of us
had experienced in our adult lifetimes, you know,
pretty much. And we got there.
In fact, we got there a year earlier than we said we
would. From then on, people started saying, actually,
they do mean business.
Like most things instead of going to zero.
Everyone became satisfied with 2% and that became the
target first in Europe and then eventually adopted by
European Central Bank.
Inflation targeting became very fashionable and like
the late 1990s, early 2000s.
Targeting 2% keeps consumer expectations anchored.
So if people can reliably expect inflation to be at or
around 2%, the target can steady a.k.a.
anchor the market.
By international standards, New Zealanders live well...
Central banks started adopting it before we got
the unemployment down.
But, economic disaster will surely arise...
The policy did lead to records of unemployment in
New Zealand.
It took a few years before unemployment came back down
to normal levels and inflation stayed low.
I actually left the Reserve Bank in 1993 thinking that,
okay, now we've solved all the problems of monetary
policy. Clearly, I've turned out to be a little
too optimistic on that front in recent years.
And this was before the US had an explicit target.
In the 1990s, that was still the Greenspan era when they
wouldn't say a number.
And have not other countries had successful results in
lowering rates of inflation as well as our country?
It's too soon to tell Mr.
Chairman.
But, it sure looked like every time inflation went
above 2%, they would raise interest rates to reduce
that. And every time we went to below 2%, they go
the other way.
After the Great Recession...
Fed Chairman Ben Bernanke's historic move tying Fed
funds to a specific unemployment rate along with
an inflation target...
The FOMC declared its target of a 2% inflation rate in
2012.
Really historic targets set by the Federal Reserve,
something very specific that people have been
screaming for.
Some economists argue that the inflation target should
be less than 2%, like Hoenig, formerly of the
Kansas City Fed.
He thinks there should be no target at all.
Instead, inflation of 0%.
And in the long run, that's the best for the economy.
I think it's more credible to have a lower target.
It's perfectly fine to fall below 2%.
Closer to zero.
I think you would be well served.
If you go back into the literature, Milton Friedman
was actually arguing for an inflation rate of about
minus two or -3% as being the optimal inflation rate.
But I think that's probably a bit too severe.
Roughly 1% deflation is not problematic in my view
because it's just reflecting the reality that
a lot of prices are falling.
People are afraid of deflation.
The fact of the matter is people become afraid of
deflation because of the Great Depression.
It's become almost stereotype.
They don't understand that it wasn't modest deflation.
It was very serious deflation.
Deflation. It is just as dangerous as inflation.
Deflation is when there is sustained downward movement
of prices for goods and services.
So, for example, it would make it harder for companies
and households to pay debts off.
Following the Great Depression, we had the
Keynesian revolution where you had more government
deficits, more government spending and therefore a
stronger likelihood of increasing inflation and
people were used to it.
So, that's how we've kind of evolved into accepting
inflation. You associate inflation with mild
inflation, not the hyperinflation we had in the
late 1970s.
Economists that argue for 2% or lower targets often point
to how aiming for anything higher may lead to higher
and higher inflation.
What are you going to get when you get to 3%?
What's it going to do to asset values?
If they're prepared to tolerate 4%,they'll be
prepared to tolerate seven or whatever, and inflation
expectations rapidly become destabilized with a higher
target.
When you start inflating, you actually invite asset
bubbles. And that is a very dangerous road for any
country to take, especially a country that is the
world's reserve currency.
Why does the central bank want to use its policies to
increase the cost of living for ordinary citizens?
It's just bananas.
But there's no evidence that
3% or 4% inflation does substantial damage relative
to 2% inflation.
In 2017, some economists wrote a letter to the FOMC
making the case for a higher target.
Are we still thinking that we could up it to this three
or 4% inflation rate?
Yeah, I signed that letter back in 2017.
And so our thought process was we should enter the next
recession where we might have to push interest rates
all the way back to zero again with a higher rate of
inflation.
Economist Lawrence Ball was also one of those signatures
on the letter.
The double digit inflation in the 1970s, Paul Volcker
and the Federal Reserve conquered inflation.
What people forget is that after the Volcker
disinflation, inflation leveled off at about 4% in
the late 1980s, and at that point, Paul Volcker was
willing to declare victory and inflation sort of went
away as a major concern or political issue.
Here's the Fed's reasoning for aiming for positive
inflation at all.
Reason one: A positive number makes it easier to
measure inflation.
We want to make sure our measurement error doesn't
push us all the way down into negative.
A slightly higher rate of kind of baseline inflation
is good for the economy and that it can sort of grease
the wheels of lots of adjustments that need to
happen.
Reason two: Aiming for inflation lowers the risk of
deflation.
Like a really extended bad recession, and so it
collapses back to the case that we should have as many
tools as possible to get us out of really steep, long
recessions.
Which brings us to three: It gives the Fed room to cut
interest rates if there's an economic downturn.
The interest rate that matters is what's called the
real interest rate. It's like the interest rate
that's posted and then you minus off inflation from
that to get the real interest rate.
If inflation is very low, then interest rates actually
can't get all that low.
Like even if the Fed puts the interest rate at zero,
if inflation is only 2%, you can only get to -2% on
interest rates. But if you need an even lower interest
rate to push the economy back to full employment to
end the recession, you're stuck.
Up until 2008, the Fed had developed a pretty effective
way of dealing with recessions.
The Fed would start cutting interest rates and that
would stimulate consumption and investment and spending.
And 2008 there was still a recession, should have cut
interest rates more, but then interest rates were
already zero.
And you can't have negative interest rates simply
because people are not going to lend money.
The 2017 letter points to how the Fed's policy rate
remained at zero for several years and there was
no acceleration of demand growth.
It's it's hard to imagine now given that we've had a
genuine problem of too high inflation for a while.
The problem from like 2009 to 2019 basically was that
the Federal Reserve had declared it had a 2%
inflation target, but it consistently was missing it
on the low side.
Inflation was just not coming in at 2% over a long
period of time. And we thought, I thought and I
think other people, in the letter agreed that that was
a problem.
The letter also argues there was a lack of evidence that
moderately higher inflation would harm American standard
of living. Instead, the letter notes tremendous
evidence that a tighter labor market would improve
standards of living.
Inflation basically helps people climb out of debt a
little faster, especially the occasional unexpected
burst of inflation is a real boon to people who have
a lot of debt.
That problem is inflation.
4% inflation was low enough for Paul Volcker.
It should be low enough for the rest of us.
Since the pandemic, the Federal Reserve replaced its
2% inflation target with some more flexible language.
It's not inflation targeting. It's average
inflation targeting
...it came after 15 Fed listening events.
Most economists agree that the Fed announcing a drastic
change to interest rates would be a PR disaster.
I think that at the moment the Fed has a little bit of
a credibility problem.
They let inflation get to 9%.
If they were to change the target, their credibility
problem would only grow.
People would say, Oh, well, changing the goalpost.
If Jerome Powell said, oh, did I say 2%?
Oh, I meant 4%.
Oh, sorry. My, my bad.
But it's 4%.
That would shake confidence in the Fed.
If we could make the change without that political
awkwardness or without losing credibility, I would
do it in a heartbeat. I understand the Fed's
reluctance.
Fed Chair Jerome Powell has said that the inflation
target of 2%, average or not, won't change any time
soon.
I'm think I'm going to retire as an economist with
the target still at 2%.
But I do think there's a chance and there are some
pretty influential people in the central banking world
who are in favor of a higher target.
So, I wouldn't rule it out entirely.
Well, I think adopting 2% is a lot better than adopting
nothing, than not having an inflation target.
So, you know, I think it's not ideal, in my view, but
it's a lot better than not having an inflation target.