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There’s rarely a convenient time for the Federal Reserve to openly debate whether its 2 per cent inflation target makes sense. This isn’t that time, but the Fed better get ready.
More urgent matters preoccupy the Fed right now. It is simultaneously stanching a crisis in the banking system while tightening financial conditions to squelch inflation.
On Wednesday, the central bank raised its benchmark Federal funds rate a quarter point to a range of 4.75 to 5 per cent. It also assured the markets that “the US banking system is sound and resilient”.
The last thing the Fed needs at this moment is further complexity in its public messaging. “We will get inflation down to 2 per cent, over time,” Jerome Powell, the Fed chair, said at a news conference on Wednesday.
Two per cent is supposed to be the sweet spot for inflation, low enough for consumer comfort but relaxed enough for the economy to flourish, according to Fed doctrine settled years ago. The Fed isn’t reconsidering it in public now.
Yet the inflation target is an important issue, one that scholars and Fed watchers are quietly discussing because it could become crucial soon. The Fed itself projects that inflation will drop to about 3.3 per cent by the end of this year and to 2.5 per cent next year. Well before that happens, it’s worth re-examining the 2 per cent target: how the Fed arrived at it, whether it still makes sense and whether current rules allow sufficient flexibility in decision making.
Inflation needs to come down, unquestionably. But with the financial tightening already underway, inflation may wane in a sustained way in the next few months. At that point, the cost in lost jobs and economic growth could be cruel and excessive if the Fed tightens further in an attempt to drive inflation down to 2 per cent, a target that is, after all, an arbitrary one.
Laurence Ball, a Johns Hopkins economist, reminded me of that in a conversation this past week. While Paul A. Volcker is now renowned for vanquishing inflation as Fed chair in the 1970s and 1980s, when he left office in August 1987, inflation was still above 4 per cent.
“If 4 per cent was good enough for Volcker,” Ball said, “it should be good enough for us.”
The 2 per cent inflation target is something of a historical accident. It has roots in New Zealand, which passed a law in 1989 establishing the independence of the country’s central bank, and, in addition, said the bank should target inflation. But what should the target be? Officials started with 0 to 1 per cent, which seemed too low, and shifted to 2 per cent.
There was no particular magic or science to the 2 per cent number, but it stuck, and it spread to other Anglophone countries in short order: Britain, Canada and Australia adopted it. So did Sweden.
Eventually, the Federal Reserve did, too, but with great reluctance.
Volcker never embraced an inflation target. He wanted inflation to be as low as possible and saw no reason to restrict the Fed’s flexibility by indicating publicly what low meant at any specific time. And Alan Greenspan, who succeeded Volcker as Fed chair, resisted setting a target for years.
He commissioned Fed economists to study the merits of a target in his first year in office, Joseph E. Gagnon told me. Gagnon, a senior fellow at the Peterson Institute for International Economics in Washington, was one of those economists.
“It was a big project,” he said. It involved computer simulations of the effects on the economy of interest rate increases needed to bring inflation below 2 per cent. “We told him we could do it, but it would be costly and would mean another recession,” Gagnon recalled.
Greenspan rejected inflation targets then, Gagnon said. “He didn’t want to be blamed for causing another recession.”
Behind closed doors, in a pivotal 1996 Federal Open Market Committee meeting, Greenspan said the Fed’s goal was “price stability”.
A transcript of the meeting shows that he defined that goal this way: “Price stability is that state in which expected changes in the general price level do not effectively alter business or household decisions,” he said.
That definition seems about right to me. He’s saying it’s OK if prices rise a little. Only when those increases feel out of control — as they have over the last year or two, and as they did in the 1970s and early 1980s — has inflation mattered to me, as a citizen and as a consumer. But where is that decisive level of inflation, exactly? I have no idea, nor did Volcker back in the 1980s. Inflation seemed under control in August 1987, when it was still above 4 per cent. The true answer, I think, is, “It depends.”
But economists, by their nature, like to put numbers on things. And in that crucial 1996 meeting, a distinguished economist and Fed official named Janet Yellen — now the Treasury secretary, and, before that, a Fed chair herself — pressed Greenspan to “please put a number on” his estimate of price stability.
The transcript shows that he said “zero” was the proper target if “inflation was correctly measured.” But it is difficult to measure inflation accurately, as everyone in the room acknowledged. So Yellen said, “Improperly measured, I believe that heading toward 2 per cent inflation would be a good idea, and that we should do so in a slow fashion, looking at what happens along the way.” That, essentially, was that.
Other Fed members agreed, and the 2 per cent target became enshrined in Fed policy, though only in a clandestine way. Greenspan did not want his hands tied. “I will tell you that if the 2 per cent inflation figure gets out of this room, it is going to create more problems for us than I think any of you might anticipate,” he said, according to the transcript.
In 2012, it finally embraced the 2 per cent target openly and formally, and made it part of the Fed’s practice of “forward guidance.” Come what may, over the long run, the Fed would veer toward its North Star, the 2 per cent inflation target.
But by August 2020, the Fed had revisited the 2 per cent target and widened its range in subtle ways. Because of that adjustment, the Fed doesn’t need to hit 2 per cent exactly. It can “average” 2 per cent “over time".
Gagnon, Ball and MIT economist Olivier Blanchard are among those who have called for an increase in the Fed inflation target to 3 per cent or 4 per cent, though they all acknowledge that as a matter of public relations, it may be better to avoid doing that right now.
Dudley said the Fed should stick with its target, at least until its next, once-every-five-years revision of its long-run strategy and goals. That’s coming up soon, though. On its own announced schedule, the Fed could start revisiting them next year and reach a formal agreement in 2025.
In the meantime, I’d say the Fed should aim high. Inflation needs to come down, but if it means throwing a lot of people out of work later this year, the Fed already has the flexibility to move slowly and mercifully. It may be wise to do so.
This article originally appeared in The New York Times
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