Should the Fed raise its 2% inflation target?

When the Federal Reserve met this week, it surprised hardly anyone by raising its Federal Funds rate for the fourth time since 2015, in this case to a target range of from 1% to 1 ¼%.  This move indicates that the Fed thinks that historically low levels of unemployment and a growing economy mean that tighter money is needed for the US central bank to meet their 2% inflation target in the long-run.  But a group of twenty-two US economists has just written to them, calling into question the 2% target, and arguing for an overhaul of the current monetary policy framework.     

The Fed’s mandate is to balance the objectives of maximum employment, price stability and moderate long-term interest rates.  For many years, interest rates were set without a formal inflation target.  Then in 2012, under the stewardship of Ben Bernanke, it adopted a 2% target, by then a common international benchmark.  However, since it was adopted, inflation has persistently fallen below 2% and is once again falling (See Chart).  This, and the prolonged period of weak employment growth since 2008, has prompted some to conclude that the Fed’s target is too stringent.

The twenty-two economists, which include Joseph Stiglitz, a Nobel Prize-winner, and Narayana Kocherlakota, a member of the Federal Open Markets Committee, argue that:

“given the evidence that the equilibrium interest rate had fallen substantially even prior to the financial crisis, and that the Fed’s short-term policy rate remained at zero for seven years without sparking any large acceleration of aggregate demand growth, a reassessment of this target seems warranted.”

They go on:

“To ensure the future effectiveness of monetary policy in stabilizing the economy after negative shocks – specifically, to avoid the zero lower bound on the funds rate – this fall in the neutral rate may well need to be met with an increase in the long-run inflation target set by the Fed.”

Josh Bivens, Director of Research at the Economic Policy Institute, has written a report which lays out the crucial arguments.  Bivens argues that structural changes in the global economy– rising inequality, the global savings glut, high levels of household debt and an ageing population – will likely mean lower interest rates not only now but into the future.  So, the economy will continue to regularly experience periods where it is operating at the Zero Lower Bound (ZLB) – when short-term nominal interest rates are close to zero.  But in such a situation, it’s important that inflation is higher, because then real interest rates (which are the key driver of output and employment) can be much lower.

“At the depths of the Great Recession, some estimates indicated that the U.S. economy needed real short-term interest rates that were negative 8 percent to restore full employment. But the lowest real interest rate that could be achieved at the ZLB during the Great Recession was negative 2 percent, far too high to restore full employment.”

The warning is clear:  unless we raise the inflation rate soon, the next time a recession hits, the Fed will find itself out of ammunition.

But Ben Bernanke, former chairman of the Fed and the architect of the 2% target, earlier this year wrote an article defending it.  While he’s sympathetic to the idea that monetary policy may need to be changed, he’s dubious about raising the target.  Changing the target might destabilise market and public confidence in the Fed’s commitment to price stability, he says, and if the Fed changed it now in response to low inflation, it raises the question of whether it would change it again if economic conditions were different. 

Instead, Bernanke suggests two alternatives:  targeting the price level, rather than inflation, and a “make up” approach to monetary policy.  On the former proposal:

“With a price-level target the Fed would commit to making up misses of its desired inflation level. For example, if inflation fell below 2 percent for a time the Fed would compensate by aiming for inflation above 2 percent until average inflation over the whole period had returned to 2 percent.” 

If this measure had been used since 2012, then the sub-2% inflation since 2012 would call for the Fed temporarily aiming for higher inflation now.  The “make up” approach (which could be used in combination) is that if the economy is stuck at the ZLB for an extended period of time, then the Fed should delay and keep rates low for longer to “make up” for the period of below-target inflation.  In other words, although there is no need to change the target, the Fed should hold fire on rate rises now, to compensate for the long-period at which the US economy was stuck at the ZLB.

Brad DeLong, Professor of Economics at University of California, Berkeley, and one of the signatories of the letter to the Fed, has written a brief blog which rejects some of the main objections to raising the target, addressing some of the points raised by Bernanke.  Against the view that the Fed already has sufficient tools at its disposal to deal with low inflation, DeLong responds that:

“This leaves begging the questions of why, then, employment has been so low over the past decade, and why production is still so low relative to our circa-2007 expectations.”    

On the issue that changing the target might undermine the credibility of the Fed, he is even more blunt:

“As my friend Daniel Davies puts it in his One-Minute MBA Course: “Is a credible reputation as an idiot a kind of credible reputation one really wants to have?”

It’s plain that inflation and employment growth have been lower than expected since the Great Recession.  So, in retrospect, it appears that monetary policy has been too tight.  One possible explanation is that the inflation target has been too low.  But if the target was too low, that wouldn’t explain why inflation has generally been sub-2% – something that is more suggestive of an unexpected weakness on the demand side of the economy, the Fed prioritising low inflation over employment growth, or faulty economic forecasts.  If so, then a change in the inflation target might not be the right solution.  Nonetheless there is a growing consensus that monetary policy regimes in the US and elsewhere – most of which were designed in very different economic conditions – are due for an overhaul. Higher targets, price targets, and “make up” regimes should all be on the table.  Our capacity to recover from the next recession is at stake.

Edited by Bill Emmott