Why 2%? Powell reconfirms Fed’s inflation target

Federal Reserve Chair Jerome Powell reiterated the central bank’s commitment to a 2% inflation target at the Jackson Hole Economic Symposium. Why 2%?

The Fed is engaged in its sharpest interest rate hiking cycle in modern history, having raised its target federal funds interest rate from essentially zero to the current range of 5.25-5.5% in 16 months. The historic Fed interest rate increases are intended to slow the US economy to bring inflation rates down from their highest levels in four decades. While inflation has receded substantially, core measures remain well above 2%, particularly inflation in the price of many services. At Jackson Hole, Powell restated the 2% commitment, saying, “Two percent is and will remain our inflation target.”

You can read a transcript of Powell’s full remarks here.

New Zealand was the first country to adopt an official 2% target for long-run inflation, during a period of particularly high inflation in the late 1980s. Soon after, Canada and England?also adopted 2%?as their inflation targets. Today, Japan and the European Central Bank also set policies with a 2% long-run inflation goal in mind. The US Federal Reserve was late to the game, announcing an official 2% target in 2012.

But why 2%?

A primary goal of all central banks is to achieve price stability. (The Fed has a second statutory mandate to work toward full employment.) While there is no universal definition, we can take price stability to mean achieving the lowest inflation rate that is practical over the long term. Low and steady inflation helps reduce losses to consumer purchasing power and creates a predictable economic environment that is conducive to business activity.

While there is no magic number for a long-run inflation goal, there are several reasons why a 2% target is reasonable:

1.???There is ample evidence that measures of inflation are biased upward. In the US, the 1996 Boskin Commission found that the Consumer Price Index (CPI) overestimates actual inflation by about 1%. That means 2% measured inflation implies experienced inflation of about 1%. That’s an enviable goal.

2.???As noted above, one of the Fed’s dual mandates is full employment, and all central banks vary interest rates to smooth the business cycle. Because inflation gets built into interest rates, a trend inflation target below 2% would give the Fed precious little room to cut rates to offset or prevent a recession.

3.???Two percent inflation is likely sufficiently high to avoid deflation, that is falling average prices. While deflation appears attractive at first blush, Japan’s “lost decades” of the 2000s and 2010s demonstrate how damaging it can be. If consumers expect lower future prices, they will hold off on big ticket spending now, and falling prices relative to costs squeeze business profits and discourage investment. Together these can create a vicious cycle of falling prices and economic stagnation.

Why not shoot for higher target than 2%? After all, as some critics have pointed out, getting to 2% may require higher interest rates for longer, risking a deep downturn rather than the soft landing that the Fed and the rest of us are hoping for, with the very damaging costs of higher unemployment. But as we have all experienced over the past two years, high inflation directly burdens consumers by reducing the real value of wages and savings, and it increases uncertainty over future inflation, which makes economic planning difficult for households and businesses.

And abandoning the 2% target would undermine the Fed’s hard-won credibility as an inflation fighter. It took many years after the disastrous 1970s and early 1980s for the Fed to establish its low-inflation credentials. Abandoning its current target risks inflation expectations becoming unmoored from their current low levels and allowing higher inflation to become embedded in labor and other contracts. Fighting inflation in the future could entail larger costs.

As we have seen, the Fed’s commitment to the 2% goal, while prudent, is not without its risks. The Fed should keep Powell’s word and “proceed carefully” as it considers possible further rate hikes, and it should begin to reduce rates as soon as inflation is clearly on a glide path toward 2%, even if that level remains some ways off. That’s the surest way for the Fed to meet its dual mandate of price stability and full employment.

#economy #jeromepowell #inflation #jacksonhole