The Fed’s Inflation Goal Is Completely Arbitrary
PHOTO ILLUSTRATION BY FIVETHIRTYEIGHT / GETTY IMAGES
Over the past 18 months, inflation has dominated our understanding of the pandemic economy. Americans have endured the highest yearly price increases in four decades, from soup to nuts — literally. Even now, as experts and forecasters worry that the economy might dip into recession, observers also remain dismayed about the relative stickiness of inflation. Through it all, we’ve heard an almost mantra-like refrain from the Federal Reserve: We’re still not close to 2 percent inflation.
It might seem odd, then, that this ostensibly carefully crafted rule of monetary policy, the goal of arguably the most powerful technocrats in the world, is sort of … arbitrary. In fact, there’s little empirical evidence to suggest that a long-run inflation target of 2 percent is the platonic ideal for balancing the Fed’s “dual mandate” of price stability and maximum employment. So as the Fed continues to raise interest rates with the stated goal of bringing us back down to 2 percent inflation, it’s worth reexamining this long-held “rule of economics.” Despite its widespread acceptance, there’s a strong case that we should understand it as a product of history — and relegate it to the dustbin accordingly.
“The idea that inflation should be relatively low and relatively stable is certainly a reasonable position to have,” said Jonathan Kirshner, a professor of political science at Boston College who studies the politics of inflation. “But there’s nothing magic or special about 2 percent.”
To understand the potential benefits — and drawbacks — of eschewing the 2 percent inflation target, it helps to know just how we arrived at this rule in the first place. Officially, a 2 percent inflation target was not adopted by the United States until 2012, when the Fed — then chaired by Ben Bernanke — decided to fall in line with the rest of the developed world’s central banks. But starting in 1996, the U.S. central bank quietly started pursuing a target rate of 2 percent under the instruction of former Chair Alan Greenspan, who wanted to keep the news under wraps. The reasons for pursuing that specific number were never clearly articulated by Greenspan, whose “covert inflation targeting” coincided with a decade of fantastic economic growth in the U.S. That lack of transparency was cause for concern for some economists.
“He didn’t think there should be a [public-facing] numerical target,” said Laurence Ball, a professor of economics at Johns Hopkins University. “He sort of went to comical lengths to not define what he meant by price stability, or to give any vague definitions.”
But according to Ball and other economists, that choice was inspired by the experiences of New Zealand, whose central bank was the first to adopt inflation targeting — a choice that caught the attention of economists around the world. The country adopted the practice because, not unlike the U.S., it had experienced double-digit inflation in the 1970s and ’80s. But in keeping with the theme of arbitrariness, New Zealand’s initial target range of 0 to 2 percent wasn’t carefully engineered either; rather, it was the result of an offhand comment made by the head of the central bank in an interview, which he called “almost a chance remark.” Not long after New Zealand adopted its target, so did Canada, and then Australia. As Ball put it, the practice then went “viral,” and eventually the U.S. joined the party — albeit secretly.
And for a long time, it appeared as if the Fed’s shadow, Kiwi-flavored inflation strategy was more or less working — or at the very least, not obviously inflicting economic hardship on millions of Americans. The Fed brings down inflation by raising interest rates, which usually has the effect of slowing the economy down, cooling growth and heightening unemployment. But for more than a decade after the Fed adopted its 2 percent goal in 1996, inflation remained under control, while gross domestic product growth and unemployment remained stable and pointing in the right direction for a healthy economy:
When things go well, people tend not to ask too many questions. But underneath those rosy topline numbers remained the issue of the empirical reasoning behind a 2 percent inflation target: We didn’t have any. And by the time we got to 2008, the 2 percent inflation target may have left us ill-prepared for the Great Recession. That’s according to some economists, including Ball, who have argued that a higher inflation target would have lessened the severity of the crisis.
“From World War II until the early 2000s, the Fed had developed a pretty effective way of fighting recessions, that it would lower interest rates, and if the recession didn’t end pretty quickly, would lower interest rates again,” Ball said. “In 2008, they lowered interest rates to zero very quickly, and still unemployment was very high. That meant there was this long, very painful, slow recovery.”
The basic argument for a higher inflation target is fairly simple, and it goes back to Econ 101. When you have a contracting or weakened economy, the Fed likes to cut interest rates to boost spending and grease the wheels of growth. The Fed is limited in how much it can do this, however, because you can’t bring interest rates below zero — at that level, a bank would be paying you to borrow money. But according to a concept known as the Fisher effect, the real interest rate people base decisions off of in their lives is equal to the nominal interest rate (i.e., the listed percentage) minus the expected inflation rate (which, in this case, is equal to the inflation target set by the Fed). So if you have a lower expected inflation rate, you would also have a lower nominal interest rate — and therefore, less space to work with before real interest rates dip below zero.
With this in mind, Ball’s research found that had the Fed targeted 4 percent inflation before the Great Recession, overall economic output would have been considerably higher — and unemployment lower — in the years following the start of the Great Recession. Additional research has found that, under certain conditions, pursuing a higher inflation target can actually improve economic stability.
Now, adopting a higher inflation target isn’t without its downsides. Kirshner, who supports the move, said the fact that recent price hikes haven’t come down as quickly as inflation doves like himself had expected is something they needed to reckon with. Others have made a slippery-slope argument, saying that raising the target by just a percentage point would beget even more inflation. And there is certainly a political danger in moving the goalposts of inflation, especially at a time when so much policy energy has been spent on counteracting inflation — not advocating for more of it. In a recent talk, Fed Gov. Philip Jefferson said that raising the inflation target would “damage the central bank’s credibility.” That conjures up some pretty gnarly images: If people don’t trust the country’s foremost financial institutions, that could have resounding effects for not just inflation, but the whole economy.
And unlike in Greenspan’s day, Fed officials now provide justification for the 2 percent target — justification which sounds plausible. As Jefferson said in that same talk, the Fed’s decision to formalize the target was based on the idea that “reasonable price stability was desirable, while also recognizing the reality that very low inflation can also be economically costly.” That accords with what economists like Paul Krugman have said, that we should understand the 2 percent rule as the result of a compromise between inflation hawks and doves.
Ball told me that he expects the Fed to continue to raise rates to bring down inflation, under the presumption of getting down to the 2 percent target eventually. But he didn’t rule out the possibility that the bank could secretly choose to adopt a de facto 4 percent inflation rate — essentially recreating the deception that Greenspan engineered decades earlier — so as not to send the economy into a nosedive, while also communicating to Americans that the Fed is serious about cracking down on inflation.
But at least at the moment, the Fed appears resolute in its quest to bring us back down to 2 percent inflation, as Powell indicated in remarks before the Senate Banking Committee earlier this week. And, like the general state of the economy right now, the notion of “reasonable price stability” remains fuzzy. Despite the fact that it has the potential to affect millions of lives, our war on inflation has a final mission that’s more subjective than not.
“You hear Fed officials or central bank officials talking about, ‘Well, price stability means 2 percent,’” Ball said. “You would think from that, either somebody has sort of scientifically figured out what’s the best inflation rate […] or maybe somewhere in the Bible or the Quran or some text, God said, ‘2 percent inflation is what we want.’ But it’s really kind of a historical accident.”