Is 2 Percent Inflation Targeting Wrong?
Since the 1990s, central banks have stuck to 2 percent as their inflation target. But what if 3 or 4 percent is better?
According to the Fisher effect1, an economy with modest inflation will usually have somewhat higher interest rates than one with zero inflation. A low but positive inflation allows the Federal Reserve to cut rates in the event of a recession.
The 2 percent target was agreed upon by policymakers and economists back in the 1990s. The goal was to have the right tradeoff between these two competing objectives: low enough that people wouldn’t have to worry too much about the future value of money, high enough that the economy would seldom reach the zero bound. The reason for keeping extra room between 2 and zero is in case the Fed must stimulate the economy by cutting interest rates to zero in order to bring back full employment (or in other words, bring the economy back to full productivity).
However, in 1999, an influential Federal Reserve research paper estimated that with a 2 percent inflation target, the economy would be at the zero lower bound only 5 percent of the time. Since the release of that paper, the U.S. economy has been at near-zero interest rates more than a third of the time. Thus, many economists now believe that the 2 percent inflation target was a mistake and should have been 3 or 4 percent instead. An example of a great economic performance of inflation at 4 percent is the second term of Ronald Reagan.
During 2022 when inflation was running around 9 percent, a 2 percent target seemed too low due to it being so distant and theoretical. Some, such as Paul Krugman, questioned whether the Fed should be focused on getting inflation all the way back to 2 percent and instead just be contemptuous with 3 or 4 percent.
Still, inflation has come down this year, defying the Phillip’s curve2 which states that as inflation comes down, unemployment must go up.
Currently, core inflation—that is inflation that excludes volatile prices such as food and energy—is at around 3 percent. The reason why the Fed doesn’t want to change to a higher inflation target is because it would damage its credibility.
This blog post was inspired by Paul Krugman’s “None Dare Call it Victory.”
1 Fisher effect is an economic theory that describes the relationship between inflation and both real and nominal interest rates. It states that the real interest rate (r) equals the nominal interest rate (i) minus the expected inflation rate (Eπ). r = i – Eπ. Therefore, the real interest rate falls as inflation increases, unless nominal interest rates increase at the same rate as inflation. https://www.investopedia.com/terms/f/fishereffect.asp
2 The Phillip’s curve is the negative relationship between inflation and unemployment. With economic growth comes inflation, and higher inflation leads to lower unemployment. With economic shrinkage comes lower inflation which leads to higher unemployment.