There’s rarely a convenient time for the Federal Reserve to openly debate whether its 2 percent 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 percent. It also assured the markets that “the U.S. 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 percent, over time,” Jerome H. Powell, the Fed chair, said at a news conference on Wednesday.
Two percent 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 percent by the end of this year and to 2.5 percent next year. Well before that happens, it’s worth re-examining the 2 percent 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 percent, 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 percent.
“If 4 percent was good enough for Volcker,” Professor Ball said, “it should be good enough for us.”
The New Zealand Example
The 2 percent 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 percent, which seemed too low, and shifted to 2 percent.
What is inflation? Inflation is a loss of purchasing power over time, meaning your dollar will not go as far tomorrow as it did today. It is typically expressed as the annual change in prices for everyday goods and services such as food, furniture, apparel, transportation and toys.
What causes inflation? It can be the result of rising consumer demand. But inflation can also rise and fall based on developments that have little to do with economic conditions, such as limited oil production and supply chain problems.
Is inflation bad? It depends on the circumstances. Fast price increases spell trouble, but moderate price gains can lead to higher wages and job growth.
How does inflation affect the poor? Inflation can be especially hard to shoulder for poor households because they spend a bigger chunk of their budgets on necessities like food, housing and gas.
Can inflation affect the stock market? Rapid inflation typically spells trouble for stocks. Financial assets in general have historically fared badly during inflation booms, while tangible assets like houses have held their value better.
There was no particular magic or science to the 2 percent 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.
Mr. 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 Mr. 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. Mr. 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 percent. “We told him we could do it, but it would be costly and would mean another recession,” Mr. Gagnon recalled.
Mr. Greenspan rejected inflation targets then, Mr. Gagnon said. “He didn’t want to be blamed for causing another recession.”
The U.S. Moves Toward 2%
Behind closed doors, in a pivotal 1996 Federal Open Market Committee meeting, Mr. 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 Mr. Volcker back in the 1980s. Inflation seemed under control in August 1987, when it was still above 4 percent. 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 E. Yellen — now the Treasury secretary, and, before that, a Fed chair herself — pressed Mr. 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 Ms. Yellen said, “Improperly measured, I believe that heading toward 2 percent 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 percent target became enshrined in Fed policy, though only in a clandestine way. Mr. Greenspan did not want his hands tied. “I will tell you that if the 2 percent 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.
Understand Inflation and How It Affects You
In those days, Mr. Greenspan and the Fed favored a style of communication that even he described as opaque. In testimony before Congress in 1987, he was droll but on the mark. “Since I’ve become a central banker, I’ve learned to mumble with great incoherence,” he said. “If I seem unduly clear to you, you must have misunderstood what I said.”
It wasn’t until 2000 that the Fed began issuing regular “forward guidance” after its meetings, projecting where it expected that the economy and inflation would be headed. By now, Mr. Powell’s news conferences have become routine. But it’s worth remembering that it wasn’t until 2011, well into Ben S. Bernanke’s tenure as Fed chair, that the central bank broke with the Volcker and Greenspan tradition of extreme circumspection and held its first regularly scheduled news conference.
In 2012, it finally embraced the 2 percent 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 percent inflation target.
A Flexible Target
But by August 2020, the Fed had revisited the 2 percent target and widened its range in subtle ways. Because of that adjustment, the Fed doesn’t need to hit 2 percent exactly. It can “average” 2 percent “over time.”
The central bank “absolutely needs to move inflation toward 2 percent” but it has some flexibility, Bill Dudley, a former president of the Federal Reserve Bank of New York, told me.
The Fed’s long-range policy statement says that it doesn’t need to get there immediately, and it has room for judgment in its timing.
But until 2021, inflation had been extremely low for a long while, often well below 2 percent. The Fed saw deflation, not inflation, as the main threat. That’s why the Fed kept short-term interest rates near zero and bought Treasuries and mortgage-backed securities. It wanted to stimulate the economy, not slow it down.
Now, the Fed is operating in reverse, with quantitative tightening, along with interest rate increases — and, lately, the still unknown effects of bank failures — all acting to constrict the economy and reduce inflation.
Mr. Gagnon, Professor Ball and the M.I.T. economist Olivier Blanchard are among those who have called for an increase in the Fed inflation target to 3 or 4 percent, though they all acknowledge that as a matter of public relations, it may be better to avoid doing that right now.
Mr. 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.
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