Ramesh Ponnuru has an excellent article in the Washington Post, pushing back at arguments for raising the inflation target to 3%:
Zandi is right that relatively steady, predictable and low inflation matters more than the exact target rate. A steady 3 percent inflation rate would even have some advantages over a lower one, such as raising nominal interest rates and thus giving central banks more room to maneuver.
That’s why 22 prominent economists wrote a letter to the Fed in 2017 urging it to consider a higher inflation target. And if we were designing a monetary policy from scratch, we might well pick a 3 percent target. But we’re not. There’s a history we have to consider.
Ponnuru argues out that a higher inflation target at this time could lead to a loss of confidence in policy, and points to the 1970s as an example of what happens when central banks lose credibility.
I share his view that this isn’t a good time to raise the inflation target. Indeed I don’t favor a higher inflation target at any time. But if we did decide to eventually transit to a 3% target, the best time to do so would be when inflation is below the 2% target and the Fed is wrestling with the “zero lower bound” problem of interest rates. When at the zero lower bound, a higher inflation target makes it easier to adopt an expansionary monetary policy.
If Fed officials ever decided that a 3% target would be better in the long run, they should make the following announcement long before this change was needed:
“We will continue to target inflation at 2% until such time as interest rates fall to zero and we are having trouble raising inflation up to 2%. At that time, we will permanently switch to a 3% target.”
Raising the inflation target now would be solving a nonexistent problem, as unemployment is only 3.6% and the Fed has plenty of room to cut rates if needed. If we are planning to do this, do it at a time where it would actually do some good.
This also caught my eye:
[T]he Federal Reserve is already hearing calls to declare its own victory over inflation, rather than continue to raise interest rates until it achieves its stated goal of bringing the inflation rate down to 2 percent.
Ponnuru rejects this argument, but I’d go even further. I get annoyed when people suggest the Fed is “fighting inflation”, as if it’s engaged in a battle with an enemy. The Fed doesn’t battle inflation, it creates inflation. On occasion, inflation can also be generated by supply shocks, but that sort of inflation is transitory. The inflation we’ve experienced over the past few years is almost entirely created by a highly expansionary monetary policy, which drove up nominal GDP. The inflation overshoot is pretty similar to the NGDP overshoot.
Prior to 1913, the average inflation rate in America was zero. Since the Fed was created, we’ve had far more inflation than deflation. The average rate of inflation is determined by monetary policy. The Fed isn’t trying to declare “victory” over inflation, they are trying to target a specific inflation rate—2% to be specific. And over the past two years they’ve done a poor job of hitting their target. They can never declare victory and rest on their laurels, they must continually strive to create 2% inflation.
Imagine a marksman shooting at a target on the side of a barn. He keeps missing badly to the right. His buddy has a bright idea, “Just paint a target around the bullet holes and declare victory.”
READER COMMENTS
Jose Pablo
Jul 14 2023 at 6:51pm
Since the Fed was created, we’ve had far more inflation than deflation. (…) And over the past two years they’ve done a poor job of hitting their target.
In your opinion, what are the wrong incentives of the Fed for this being the case?
Scott Sumner
Jul 14 2023 at 9:07pm
I’d say it’s more a question of the wrong model rather than the wrong incentives.
Physecon
Jul 15 2023 at 9:59am
I’m not sure this is a great strategy either as it opens the door to un-anchoring expectations. If the Fed says that the switch is conditional on short term conditions (“having trouble raisrng inflation up to 2%”) then that means after setting 3% they may have trouble and raise the target to 4%, then possibly to 5%, then….
As long as level targetting is not part of their strategy then they can always find themselves in a position struggling to reach their target.
Scott Sumner
Jul 15 2023 at 12:03pm
I completely agree. My only point was that if we decide to do the switch (unwise in my view), this is not the right time.
spencer
Jul 15 2023 at 12:03pm
If the FED was fighting inflation, then the U.S. $ wouldn’t be falling. It would be rising, like during the “Taper Tantrum”. I.e., QE4 was really QT.
Ben
Jul 15 2023 at 4:46pm
Wouldn’t a higher inflation target create higher real GDP and higher real wage growth? When consumer demand is growing, not all of it is ‘eaten up’ by increasing prices, otherwise we would never have any real terms growth. If there was more wriggle room for firms to pass on the costs of expansion to consumers, aggregate demand could be higher, and there would be more demand ‘left over’ which ordinary people would experience as increased disposable income.
Max
Jul 15 2023 at 5:48pm
I find it surprising that in the whole article there is no mention of out of control government spending. This spending forces to fed to monetize the debt and is a direct contributor to inflation. A 3% inflation rate means prices double every 24 years. Of course, the way they measure inflation now is nowhere close to the actual inflation the American people are experiencing. A 3% inflation rate what only allow more irresponsible government spending and no doubt would lead to The fat battling 5 – 6% inflation to get back to the three level. Without getting government spending under control The Fed is almost powerless unless, of course, they refuse to monetize the death and let our government default. Not likely.
Scott Sumner
Jul 16 2023 at 11:51am
I don’t see any evidence that the Fed is forced to monetize debt.
spencer
Jul 16 2023 at 1:43pm
re: “I don’t see any evidence that the Fed is forced to monetize debt.”
That monetization would be indicated by the decline in O/N RRP volumes.
The current environment reminds me of the Case of the Missing Money STEPHEN M. GOLDFELD Princeton University. TDs are being activated by saver-holders.
Shadow stats refers to this as: “The most-liquid “Basic M1” (currency plus Demand Deposits) held 118.1% above its Pre-Pandemic Level and is increasing year-to-year, versus the Aggregate M2 Money Supply holding up by 30.0%, but declining year-to-year”.
M2/GDP is still too high.
All monetary savings, income not spent, originate within the confines of the payment’s system. The source of interest-bearing deposits is non-interest-bearing deposits. DDs are just shifted into TDs within the system. All the deposits are created ex-nihilo by the Reserve and commercial banks.
Unless monetary savings, income held beyond the income period in which received, are expeditiously activated by their owners, saver-holders, a dampening economic environment is fostered, i.e., secular stagnation. In the current situation, we have the opposite scenario, where TDs are being activated.
vince
Jul 16 2023 at 2:07pm
Are there any serious studies on why a 2 percent inflation rate, or any inflation rate, is ideal? The sticky price and wage argument, for example, could be due to expectations.
It’s devious to say that the Fed’s objective of stable prices mean a steady rate of decline in value.
Inflation has distributional effects. Why should those on a fixed pension be penalized by a targeted devaluation of money?
spencer
Jul 16 2023 at 2:15pm
Your formatting sucks. RE: ” don’t see any evidence that the Fed is forced to monetize debt.”
That’s exactly what the O/N RRP volumes indicate.
spencer
Jul 16 2023 at 2:24pm
Are there any serious studies on why a 2 percent inflation rate? Yes, and they’re very old school. They’re called Monopolistic price practices.
vince
Jul 16 2023 at 3:18pm
Could you explain further. Also, thanks for the DL Thornton reference. Great site.
spencer
Jul 16 2023 at 2:27pm
re: Why should those on a fixed pension be penalized by a targeted devaluation of money?
Yeah, free markets don’t work.
spencer
Jul 16 2023 at 2:43pm
As Dr. Philip George puts it: “Changes in velocity have nothing to do with the speed at which money moves from hand to hand but are entirely the result of movements between demand deposits and other kinds of deposits”.
spencer
Jul 16 2023 at 3:11pm
Link: Daniel L. Thornton, May 12, 2022:
“However, on March 26, 2020, the Board of Governors reduced the reserve requirement on checkable deposits to zero. This action ended the Fed’s ability to control M1.”
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That’s exactly what’s happening. Transaction accounts are being increased relative to gated deposits.
spencer
Jul 17 2023 at 10:28am
Inflation is exacerbated by our trade deficits, by foreigners acquiring stock in our country, real estate, equities, etc. Our cumulative trade deficit since 1985 is > 18 trillion dollars.
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