Is It Time for the Fed to Retire the 2 Percent Inflation Target?
Introduction:
For nearly a decade, the Federal Reserve has maintained a 2 percent inflation target as part of its monetary policy. However, there is now a growing chorus of market watchers suggesting that it might be time to reconsider this objective. Some economists argue that the current target may not be suitable for today’s economy and that raising it could send the wrong signal to consumers. Despite these calls for change, Fed Chair Jerome Powell has repeatedly stated that the 2 percent target is here to stay. So, why are economists divided on this issue, and what are the potential implications of changing or maintaining the inflation target?
The Case for Keeping the 2 Percent Target:
Many economists believe that the 2 percent inflation target is worth keeping. During an event hosted by the Brookings Institution, experts overwhelmingly agreed that maintaining this objective is essential. Former Federal Reserve Vice Chair Don Kohn, who initially opposed the target rate in 2003, changed his mind after the Global Financial Crisis in 2008. He argued that the 2 percent target performed well during that period and has proven its worth.
Michael McMahon, a professor of economics at the University of Oxford, highlighted the challenges of adjusting the target when inflation is running above 3 percent. He noted that it could give the impression that policymakers are shifting the goalposts. McMahon suggested that if there were a desire to revise the target, the Fed should first restore inflation to 2 percent and then engage in a framework discussion on a new figure. Ultimately, he concluded that the 2 percent inflation target is “pretty good.”
The Origins of the 2 Percent Target:
The 2 percent inflation target became the international standard for central banks following its establishment by the Reserve Bank of New Zealand in 1990. Other countries, including Canada and the United Kingdom, adopted similar goals. Economist Milton Friedman’s suggestion in his 1969 book, “The Optimum Quantity of Money,” that 2 percent is the optimal rate that balances households’ interests with economic conditions may have influenced this choice.
Critics of the 2 Percent Target:
Despite its widespread adoption, some economists have questioned the validity of the 2 percent inflation target in recent years. In a letter to the Federal Open Market Committee (FOMC), nearly two dozen economists argued that economic changes necessitate a rigorous reassessment of previously-accepted policy parameters. They specifically called for a reevaluation of the low inflation targets that have guided monetary policy for decades.
New York Fed President John Williams, however, defended the target, emphasizing its importance in achieving price stability and facilitating economic prosperity. He highlighted the significance of transparency, clear communication, and setting an explicit, numerical longer-run inflation target in anchoring inflation expectations and keeping inflation at the desired level.
Consumer Expectations and the Inflation Target:
While economists debate the merits of the 2 percent inflation target, consumer expectations suggest skepticism about the Federal Reserve’s ability to return inflation to this level. According to surveys conducted by the New York Fed and the University of Michigan, households’ one-year and five-year inflation outlooks consistently exceed 3 percent.
Conclusion:
Although there is a growing debate surrounding the Federal Reserve’s 2 percent inflation target, economists remain divided on whether it should be retired or maintained. Those in favor argue that it has performed well and is worth keeping. Critics suggest that economic changes necessitate a reassessment of the target and question its validity in today’s economy. Regardless of the ongoing discussion, maintaining transparency and clear communication with the public about the Fed’s monetary policy objectives will be crucial in anchoring inflation expectations and fostering economic stability.
