Federal Reserve’s 2 Percent Inflation Target Is ‘Worth Keeping,’ Economists Say

Federal Reserve’s 2 Percent Inflation Target Is ‘Worth Keeping,’ Economists Say
A cyclist passes the Federal Reserve building in Washington, on Aug. 22, 2018. (Chris Wattie/Reuters)

Economists believe the Federal Reserve’s 2 percent inflation target is “worth keeping” and shifting the goalposts would send the wrong signal to consumers.

Since 2012, the U.S. central bank has officially maintained a 2 percent inflation target, though monetary policymakers had settled on this figure behind the scenes in the 1990s.

With inflation proving to be sticky and progress on restoring price stability slowing, there has been talk in the public arena that the Fed should reconsider this objective.

“Consistency in Fed guidance is a crucial element for financial and economic stability, so considering this change does not come lightly,” said Joe Brusuelas, the chief economist at RSM, in an October 2023 paper. “We suggest an incremental approach as the Fed quietly raises the tolerance level for inflation to a 2.5 percent to 3 percent range while keeping its policy rate at 5.5 percent.”

In 2018, David Wessel of the Brookings Institution argued that the Fed should lift the inflation target while also shooting for 2 percent.

“One alternative to the Fed’s current approach would be to keep targeting the inflation rate, but to raise the target from the current 2 percent, perhaps to 3 percent or 4 percent,” Mr. Wessel wrote.

The 2 percent target might have been a good policy when it was instituted, “but may not be the best choice for today’s economy,” he noted.

However, Fed Chair Jerome Powell has insisted that the 2 percent target is not going anywhere.

Speaking to reporters at a post-meeting press conference in December 2020, Mr. Powell shrugged off the proposals.

“We’re not considering that. We’re not going to consider that. Under any circumstances,” the central bank chief told reporters. “We’re going to keep our inflation target at 2 percent. We’re going to use our tools to get inflation back to 2 percent.”

At last year’s Jackson Hole Economic Symposium, Mr. Powell reiterated the central bank’s 2 percent commitment.

“Two percent is and will remain our inflation target,” he said.

Economists say that is a wise decision.

Inflation Target Is ‘Worth Keeping’

The Brookings Institution, an economic think tank, hosted an event assessing the Fed’s review of its monetary policy framework.

During the afternoon session, experts were asked if it was time to reconsider the 2 percent target. The overwhelming consensus was that it is “worth keeping” this objective intact.

While former Fed Vice Chair Don Kohn initially opposed the inflation target rate in 2003 because it would tie the institution’s hands and prevent the Fed from adapting to various economic conditions, he changed his mind after the Global Financial Crisis in 2008.

Mr. Kohn explained during the panel discussion on Friday that if the Fed adopted a 2 percent target, it would have encouraged Federal Open Market Committee (FOMC) policymakers during the Great Recession to help then-Chair Ben Bernanke and become more aggressive in stopping the sharp economic downturn and returning inflation back to 2 percent.

“I think it has performed well and is worth keeping,” Mr. Kohn said.

Michael McMahon, a professor of economics at the University of Oxford, argued that it would be more challenging to adjust the number when inflation is running above 3 percent because it looks like officials “are shifting the goalposts.”

If there were an appetite to revise the target, the Fed would have to restore inflation to 2 percent and then have a framework discussion on a new figure.

“That’s the right way to sequence it,” Mr. McMahon noted, adding that he could understand “how central banks get nervous at this point.”

Ultimately, however, the 2 percent inflation target is “pretty good,” he said.

Why the Fed Chose 2 Percent

In 1990, the Reserve Bank of New Zealand established a goal of 1 percent to 3 percent inflation, prompting other countries, such as Canada and the United Kingdom, to follow suit.

Eventually, 2 percent became the international standard for central banks.

When pressed by the Senate Banking Committee members as to why there is a 2 percent inflation goal, Mr. Powell explained that the public’s expectations “actually have an effect on inflation.”

“If you expect inflation to go 5 percent, then it will,” Mr. Powell said at a semi-annual monetary policy hearing in March 2023.

The 2 percent concept might have been influenced by economist Milton Friedman. In his 1969 book “The Optimum Quantity of Money,” Friedman suggested that this is the optimal rate that does not penalize households while also adapting to economic conditions.

In recent years, some economists have pushed back against this notion.

Writing in a 2017 letter to the FOMC, nearly two dozen economists purported that “economies change over time.”

“Policymakers must be willing to rigorously assess the costs and benefits of previously-accepted policy parameters in response to economic changes,” they wrote. “One of these key parameters that should be rigorously reassessed is the very low inflation targets that have guided monetary policy in recent decades.”

New York Fed president John Williams defended the target by arguing that it is paramount to achieving price stability and facilitating economic prosperity.

“Theory and experience have also shown the importance of transparency and clear communication, including setting an explicit, numerical longer-run inflation target, and of taking appropriate actions to support the achievement of that goal,” Mr. Williams said at a monetary policy conference at Stanford University’s Hoover Institution.

“These are critical in anchoring inflation expectations, which, in turn, help keep inflation at the target.”

Whether the Fed keeps the target intact or not, consumers doubt that the central bank will return inflation to this level.

According to the New York Fed’s May Survey of Consumer Expectations (SCE), households’ one-year outlook was 3.2 percent, and the five-year horizon was 3 percent.

The June University of Michigan’s one- and five-year inflation expectations were above 3 percent.

From The Epoch Times