Academic journal article The Cato Journal

A Critique of Proposals to Raise the Fed's Inflation Target

Academic journal article The Cato Journal

A Critique of Proposals to Raise the Fed's Inflation Target

Article excerpt

During the last seven years, the unemployment rate fell from 10 percent to less than 5 percent, but policymakers say that there is still an underutilization of labor resources. Why? Because inflation is below the Federal Reserve's 2 percent target and GDP is below official estimates of potential GDP. Normally, in this situation the Federal Open Market Committee (FOMC) would lower short-term interest rates in order to stimulate aggregate spending. However, short-term interest rates are near zero--as low as they can go when people have the alternative of holding cash. Those who want to use lower interest rates to stimulate the economy also want a higher inflation target so that when the economy is at full employment nominal interest rates will be higher, and when something bad happens, policymakers will have more flexibility to lower interest rates before hitting the zero lower bound.

In a Financial Times interview on April 20, 2015, Federal Reserve Bank of Boston President Eric Rosengren called on his fellow policymakers at the Fed and around the world to consider raising their inflation targets: "As we learn more about the real interest rate potentially being lower, we may at least want to have a broader debate about whether we have set the inflation targets too low" (Fleming 2015). The rationale for a higher inflation target does not depend on there being a long-run tradeoff between inflation and unemployment. It is about countercyclical policy, the desire to have plenty of flexibility for the Fed to lower interest rates when there is a string of bad news. Others, who do believe that there is a long-run tradeoff between inflation and unemployment, also call for permanently higher inflation. They think that inflation aids labor market adjustments when the demand for labor falls both for an individual firm and for the economy overall.

This article explains why a higher inflation rate is not a good idea. As a cyclical policy, it would do more harm than good and, as a permanent policy, would not take us to a better economy. I begin by reviewing the calls for more inflation, explaining the rationale that is put forward for each case. Next, 1 lay out the reasons why raising the inflation target would be a bad idea. In particular, raising tire inflation target damages the value of inflation targeting as a nominal anchor. Moreover, I summarize what we have learned about the costs of inflation, both anticipated and unanticipated. Finally, I explain why the perceived benefits suggested by advocates of higher inflation are ephemeral and not likely to be achieved in practice.

Calls for Higher Inflation

Some economists have recommended that the Federal Reserve raise its long-run inflation target from 2 percent to 4 percent--not because they think this would be useful in the near term, but rather because they think a 4 percent inflation economy would perform better than a 2 percent inflation economy. To the best of my knowledge, this argument was first made by Summers (1991) at a conference on the optimal inflation target sponsored by the Federal Reserve Bank of Cleveland and the Journal of Money, Credit, and Banking in October 1990. He specifically commented on proposed legislation, House Joint Resolution 409, which would have mandated a zero inflation target for the Federal Reserve. More recently, Ball (2014) and Blanchard, Dell'Ariccia, and Mauro (2010) have argued that 2 percent steady state inflation is too low and causes market interest rates to hit zero too often, frustrating Fed attempts to promote full employment.

The reasoning is simple and rather mechanical, involving two ideas. The first is simply that the market interest rate is the sum of the real return and the expected inflation rate that should be equal to the inflation target. A higher inflation target during normal times means higher inflation expectations and a higher market interest rate, giving the Fed more room to lower the policy rate when a recession begins. …

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