Rethinking the 2% Inflation Target: The Federal Reserve's Dilemma

As the Federal Reserve grapples with high inflation, public sentiment, economic the debate over the 2% inflation target has resurfaced, with experts weighing the merits of a more flexible approach.

Jun 12, 2024

The Facts:

The Federal Reserve is currently faced with a dilemma regarding inflation. While their preferred measure of consumer prices has improved from a year earlier, it is still higher than the 2% target they aim for. This has led to a debate among economists and policymakers about whether the 2% inflation target is still appropriate.

Before the pandemic, some economists considered high inflation a "high-class problem," as low inflation and extremely low interest rates were making it difficult for the Federal Reserve to stimulate the economy during recessions. To address this, prominent economists like Olivier Blanchard and Laurence Ball had pushed for a much higher inflation target, such as 4%, as they believed the real natural interest rate had fallen, putting the economy in a perilous state. A higher inflation target would allow the Fed to set interest rates higher, giving them more scope to cut rates in the event of a recession. They argued that a 4% target would provide better economic stability.

However, the recent experience of high inflation has made the public deeply averse to even relatively modest levels of inflation. Surveys have shown that people view a one percentage-point increase in the inflation rate as twice as bad as a one percentage-point increase in the unemployment rate. The psychological toll of constantly having to rethink budgets and deal with the complexity of high inflation has made the public highly intolerant of it. As a result, some economists like Jón Steinsson have changed their views, now believing that the 2% target makes sense, as it aligns with former Fed Chair Alan Greenspan's view of the right level of inflation - when people don't consider it a factor in their decisions.

The 2% inflation target itself is somewhat of a historical accident, with its roots in New Zealand's central bank policies in the 1980s. It then spread to other countries, including the United States, but with great reluctance from former Fed Chairs like Paul Volcker and Alan Greenspan, who preferred to maintain flexibility in their approach to inflation. In a pivotal 1996 Federal Open Market Committee meeting, Alan Greenspan defined "price stability" as a state where expected changes in the general price level do not effectively alter business or household decisions. Janet Yellen, then a Fed official, pressed Greenspan to "put a number on" his estimate of price stability, which led to the adoption of the 2% inflation target, though it was initially kept clandestine. The Fed in 2012formally adopted the 2% target but has in 2020 introduced some flexibility in how it is implemented, by claiming it is targeting an "average" 2% "over time." This allows the Fed to have some judgment in the timing of achieving the target, rather than requiring it to be hit immediately.

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The View:

The Federal Reserve is facing a complex and nuanced challenge when it comes to the appropriate inflation target. While the 2% goal may have made sense in the past, the recent experience of high inflation has clearly shown that the public has a deep-seated aversion to even relatively modest levels of price increases. There is merit in the arguments made by economists like Blanchard and Ball, who advocated for a higher 4% inflation target, as this could provide the Fed with more flexibility to respond to economic downturns.

However, the public's visceral dislike of inflation, driven by both financial and psychological factors, makes it politically and practically challenging for the Fed to adopt such a target, at least in the near term. The Fed should carefully consider the flexibility it already has in the current 2% target, which allows for "averaging" over time and some judgment in the timing of achieving the goal. Pushing too hard to drive inflation down to 2% in the short term could result in excessive economic pain and job losses, which may not be justifiable given the arbitrary nature of the 2% target.

Ultimately, the Fed should aim high in its approach to inflation, recognizing that a slightly higher target may be more appropriate and less damaging to the economy. However, the public relations challenges this would entail and suggests that the Fed may be wise to stick with the current 2% target, at least until its next formal review of its long-term strategy and goals, which is expected to happen in the coming years.

TLDR:

The Federal Reserve is facing a dilemma regarding inflation, with their preferred measure still higher than the 2% target.
Before the pandemic, some economists advocated for a higher 4% inflation target to provide the Fed with more scope to stimulate the economy during recessions.
However, the recent experience of high inflation has made the public deeply averse to even relatively modest levels of inflation, driven by both financial and psychological factors.
The 2% inflation target itself is a historical accident, with its roots in New Zealand's central bank policies in the 1980s.
The Fed has introduced some flexibility in the implementation of the 2% target, allowing for "averaging" over time and some judgment in the timing of achieving the goal.
Pushing too hard to drive inflation down to 2% in the short term could result in excessive economic pain and job losses, which may not be justifiable given the arbitrary nature of the 2% target.
The Fed should consider a slightly higher inflation target, but the public relations challenges may lead them to stick with the current 2% target, at least until the next formal review of its long-term strategy and goals.