A critique of proposals to raise the Fed's inflation target.

AuthorGavin, William T.

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. The second idea, open to debate, is that lower interest rates will lead to more aggregate demand and more output. Ball calculates that "if interest rates had been two points lower during 2009, output in 2010 would have been 2 percent higher." Moreover, he argues that "the output gain for 2013 would be 5.9 percent, and the cumulative gain over 2010-13 would be 16.4 percent of annual output" (Ball 2014; 4-5). Similar calculations can be found in Blanchard, Dell'Ariccio, and Monro (2010).

Well before the 2008-09 financial crisis, Akerlof, Dickens, and Perry (1996 and 2000) argued in favor of higher inflation targets. They want a higher inflation target in order to "grease" the labor market. They assume that workers are ignorant about tire effects of inflation on tire market for their labor services. These workers would rather have the purchasing power of their paycheck cut by inflation than take a direct cut in their nominal take-home pay. They argue that workers fail to understand that inflation increases wages elsewhere in the economy, so that other wages will be rising while theirs are held constant. Their relative wage will fall just as it does in the case where they get an explicit wage cut. They calculate that "the difference in the sustainable rate of unemployment between operating with a steady 3 percent inflation rate and a steady zero percent inflation rate is estimated as 1 to 2 percentage points" (Akerlof, Dickens, and Perry 1996: 51). Essentially, these authors are arguing that higher inflation will reduce conflict in labor markets and lead to higher aggregate output. Ironically, they are arguing that, by confusing individuals about die relative price of labor, the higher inflation will improve economic efficiency.

There were also calls for a temporary increase in the inflation target made early in the financial crisis. The sharp decline in housing and other asset prices in 2008 and 2009 left many highly leveraged homeowners and investors underwater with debt levels that were thought to be a drag on economic recovery. Kenneth Rogoff recommended that the Fed pursue 6 percent inflation for a couple years to help such debtors (see Evans-Pritchard 2009). In 2011, during an NPR interview, he recommended that the Fed print money until the inflation rate reached 5 percent (National Public Radio 2011). Since most debt is fixed in nominal terms, the policy would intentionally shift wealth from creditors to debtors. Rogoff (2014) clearly intended this to be a temporary policy as he argues against Ball's permanent 4 percent inflation target.

The Inflation Target as a Nominal Anchor

The adoption of inflation targets to stabilize the purchasing power of paper money evolved gradually, after almost two decades of failing attempts to implement money supply targets. The need for a nominal anchor became apparent in the late 1960s and early 1970s as the modified dollar/gold standard adopted at Bretton Woods began to come apart. The U.S. dollar lost its (admittedly weak) anchor to gold and the result was high and uncertain inflation. (1) Initially, the government used wage and price controls to try to control inflation. But the economic distortions were obvious. There were many shortages and non-price rationing schemes such as lines at gasoline stations. The price controls were abandoned and economists debated about how to repair the damage and implement a new anchor for the dollar. Monetarists, led by Milton Friedman, advocated a fixed growth rate for tire money supply. In 1976, Congress passed a resolution requiring the Fed to announce targets for tire money supply. Congressman Ron Paul (R-TX) and Lewis Lehmran (1982) called for a return to tire gold standard. Others recommended...

To continue reading

Request your trial

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT