The Fed’s Inflation Goal Is Completely Arbitrary
Mar. 9, 2023, at 6:00 AM
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.
Why is 2% the Federal Reserve’s magic number for inflation? | FiveThirtyEightAll VideosYouTube“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.
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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:
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Originally posted on: https://fivethirtyeight.com/features/why-the-feds-want-2-percent-inflation/