Written by Ethan Messeri
Inflation has been in the news a lot lately. Recently, it has always been in the context that inflation is too high. From eggs to rent prices, everything is going up, and whenever someone talks about inflation, lower is always better. However, as many know, the Federal Reserve, the central bank for the United States, has had a de facto target rate of inflation at 2% and an official target rate ever since 2012. So why does the Fed want some level of inflation? Why should the target not be 0%? After all, no one likes it when prices rise, so why not 1%? Why not negative inflation or deflation? Is there a reason for 2%?
The story of the 2% inflation target starts oddly in New Zealand. In 1989, New Zealand wanted to codify the independence of its central bank, and in this bill, it directed the New Zealand finance minister and head of its central bank to come up with an inflation target (Irwin 2014). If this target was not met, then the head of the central bank could be fired. According to David Caygill, New Zealand’s finance minister at the time, “Inflation targeting wasn’t from our point of view the main point of the act,” and establishing the bank’s independence from political processes was far more important (Irwin, 2014). There were some concerns that a target would lead to higher employment, but the main opposition to the inflation target was in the hospital at the time. Once the bill became law, then an inflation target had to be chosen. In an off-hand remark in an interview, the former head central banker said the inflation target should be zero to 1 percent. However, Don Brash, the head of the central bank, claimed “It was almost a chance remark,” and “The figure was plucked out of the air to influence the public’s expectations ”(Irwin, 2014). They used this number as a starting point and pushed it up to 2% to give themselves a bit more room.
One could easily believe that an arbitrary number based on lack of political opposition and an off-hand comment by a central banker would not have much effect, but that assumption would be wrong. Once the central bank said that inflation would be 2%, everyone else assumed that it would be too, since the central bank could use monetary policy to change the inflation rate. For example, contracts assumed a 2% inflation rate, which means wages would only rise 2% a year. This meant that costs only would have to rise 2%, meaning that inflation slowed. It also got rid of the inflationary cycle where one buys goods now since they now believe they will be much more expensive later, creating a shortage of goods and an increase in prices. In 1989, the inflation rate was 7.6% in New Zealand, and by 1991 it was 2%. Countries started to take notice, and Canada and Britain implemented inflation targets shortly after (Irwin,2014).
The United States was having a debate about the inflation rate the Fed should target, at the same time. Paul Volcker, who was Fed chair from 1979 to 1987, and his succeeding Fed Chair, Alan Greenspan, who served during this time period and until 2006, favored an inflation rate that was 0% to 1% (Sommer, 2023). They argued that this target was minimal enough to not affect business decisions, and prices would stay stable. However, Fed Governor and later Fed Chair, Janet Yellen, favored a higher inflation target that would allow for the Fed to take greater action if there was a recession (Sommer, 2023). She argued that, if there is a recession and the inflation rate is already very low, then there would be a high risk of deflation. Although the idea of a more valuable dollar may sound great, many economists think it is worse than high inflation (Engeman, 2019). The problem is that the value of money would increase when people do nothing with it. This would be problematic since people would not invest or spend money to get the country out of a recession when they could just get a return from doing nothing. Instead of taking a risk and investing the money, the velocity of money decreases, and there is less spending leading to higher unemployment and less growth. The cycle could then create more deflation and less spending, putting the country into a self-fulfilling recession cycle.
During the late 1990s, Japan saw the deflationary fear come true, where a deflationary economy created a decades-long stagnation. Combined with the mild 2001 post 9/11 recession, the argument to have a higher inflation target in the U.S. was strengthened (Irwin,2014). Thus, the implicit 1% target started gradually increasing. One analysis of FOMC meetings found that the Fed preferred an implicit target of 1.5 core inflation from 2000 to 2007 (Shaprio, Wilson, 2019). However, after the 2008 recession, the consensus shifted to a compromise of 2% inflation target in line with New Zealand, which was later made official in 2012 by Fed Chair Ben Bernanke, which is still in place today (Shapiro, Wilson, 2019).
The above current events show that an inflation target has some power and inflation seems to show that inflation targets have some power. A study by the IMF confirms this and says, “Nonetheless, empirical evidence on the performance of inflation targeting is broadly, though not totally, supportive of the effectiveness of the framework in delivering low inflation, anchoring inflation expectations, and lowering inflation volatility. Moreover, these gains in inflation performance were achieved with no adverse effects on output and interest volatility” (Jahan, 2010). However, is 2% the right number? The first problem is that if the Fed does change its inflation target, it loses a lot of its credibility, which is what the inflation target’s power comes from.
This loss of trust is a major problem. For example, if you no longer believe the Fed inflation target, then you will base your actions on what you think the inflation rate will be, which can lead to cycles of inflation. If you believe inflation will be high soon, you will buy a lot of stuff now when prices are lower. However, other people will realize this too, and then there will be a race to buy goods and services, which will lead to less supply and higher prices. This creates more demand, which leads to higher prices, creating the inflationary doom loop. Showing that losing the Fed’s credibility may not be worth the benefit of a better target.
The story of the inflation target is one which is much more random and less thought through than you would expect. A politician and central banker which few around the world knew changed world economic history, and created one of the most powerful monetary policy tools. However the world has cemented this target into the core assumptions of the world economy and there would be repercussions all around if we changed the target. Each target has trade offs but perhaps finding an optimal level would lead to a more prosperous world.
Bibliography
Engamann, K. (2019, January). The fed’s inflation target: Why 2 percent? Federal Reserve Bank of St. Louis; Federal Reserve Bank of St. Louis. https://www.stlouisfed.org/open-vault/2019/january/fed-inflation-target-2-percent
Irwin, N. (2014, December 19). Of kiwis and currencies: How a 2% inflation target became global economic gospel. The New York Times. https://www.nytimes.com/2014/12/21/upshot/of-kiwis-and-currencies-how-a-2-inflation-target-became-global-economic-gospel.html
Sarwat, J. (n.d.). Inflation targeting: Holding the line. BACK T O BASICS COMPILATION. https://www.imf.org/external/pubs/ft/fandd/basics/72-inflation-targeting.htm
Sommer, J. (2023, March 24). The fed has targeted 2% inflation. Should it aim higher? The New York Times. https://www.nytimes.com/2023/03/24/business/inflation-federal-reserve-interest-rates.html