Why Do We Target 2% Inflation?
November 23, 2015
For over two decades now, the Federal Reserve has targeted a 2% inflation rate per year. While hardly drawn into question over that time, the Fed’s inability to stimulate the economy by keeping the benchmark interest rate close to zero has made the targeted inflation rate a more contentious topic recently. Yet, the 2% inflation rate serves as a point of stability and reliability for the public, which was one of the main reasons it was chosen in the first place.
Back when the U.S. was still using the gold standard, monetary policy used to consist of simply controlling the exchange rate. Policymakers would take money out of the economy to raise the price of the dollar and to stabilize the exchange rate; however, this would hurt the economy and helped lead to the Great Depression.
After the Depression, policymakers shifted their focus on employment, believing the economy followed the Phillips curve. The Phillips curve shows a trade-off between inflation and unemployment, with a rise in one leading to a drop in the other. They believed in this until the period of Stagflation in the 1970s, where the U.S. had high inflation and high unemployment.
Central Banks soon realized they needed to focus on one economic variable, a variable that allowed policy to be easily altered if the economy was not going to meet the target. Thus, they chose to use the inflation rate because it clearly showed the health of the economy. Based on the Fed’s mandate, which says that they want to maximize price stability and employment, and an economic analysis of the consequences of a high versus low inflation rate, the Fed chose 2% as a reasonable target.
One of the primary arguments against setting a higher target inflation rate is that doing so would cause greater volatility. In the Fed’s own words, “a higher inflation rate would reduce the public’s ability to make accurate long-term economic and financial decision.” Since the inflation rate determines the rate at which prices increase, setting it higher would hurt people’s buying power and force them to set aside more money for spending because they essentially have to pay more for the same good.
On the other side, a low inflation rate is often associated with economic weakness and nullifies some of the effect of monetary policy meant to stimulate the economy. Low inflation can lead to lower interest rates because when issuing loans or bonds, lenders will demand a premium to account for inflation. When interest rates are low, the Fed will often reduce the benchmark interest rate in order to encourage spending, consequently boosting the economy and preventing economic weakness. As the benchmark interest rate gets very low and even approaches the zero lower bound, however, the Fed becomes increasingly powerless; they can no longer lower interest rates and expansive monetary policy becomes relatively useless and unfeasible.
More recently, many people have made cases for a higher inflation rate. While the Fed has indicated on multiple occasions that it might finally raise the benchmark interest rate, it has not done so due to the lack of economic growth the U.S. has been experiencing. Despite aiming for 2% inflation, the Fed has fallen well short of the target as well, with the current inflation rate sitting at just 0.2%.
(Image: Consumer Price Inflation. Source: The Economist explains Why the Fed Targets 2% Inflation)
One proposition, made by Johns Hopkins economics professor, Laurence Ball, was to raise the inflation rate to 4% in order to avoid hitting the zero lower bound. Raising the target inflation rate would enhance the Fed’s ability to stimulate the economy during recessions and avoid having interest rates reach 0%. Yet, others argue that the Fed actually maintains considerable power to stimulate growth even when interest rates approach 0%. As John Williams, the president of the Federal Reserve Bank of San Francisco, indicated, even when interest rates drop, the Fed can stimulate the economy through its bond purchasing programs, such as quantitative easing, and by simply keeping the interest rates near zero.
Overall, explaining exactly why the inflation rate is 2% is difficult, but the choice is not arbitrary. The number serves as an anchor for people and the fundamental reasoning was to provide the public with a stable and predictable indicator of economic strength. Therefore, even with some fresh arguments for raising the inflation rate gaining prominence, the target inflation rate is likely to remain at 2% for the foreseeable future.
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