Federal Reserve Chair Jerome Powell briskly dispensed with the idea of raising the central bank’s inflation target in his speech at the Jackson Hole conference last week. But the idea isn’t going away. It has influential supporters, and they make a strong case. What’s more, they might get their way even if the Fed denies that’s what is happening. The central bank could raise the 2% target tacitly while insisting it has done no such thing. This might, in fact, be the likeliest outcome.
It would be a pity. The better answer is to keep the 2% target and strive to hit it while acknowledging the limits of what the Fed can do on its own. Bringing fiscal policy to bear is the key. If that could be done less haphazardly, the central bank’s job would be easier and the costs of keeping inflation in check would fall.
Leaving fiscal policy aside for a moment, there are two main arguments for raising the target. The first says the benefit of cutting inflation from the current headline rate of 3.2% to 2% would be so small that the cost – lost jobs and output at best and maybe an outright recession – isn’t justified. Unfortunately this reasoning also applies to raising the target from 3% to 4%, or from 4% to 5%. At each step, the difference in inflation looks trivial and the cost of reversing it isn’t. This logic says the target is no longer binding, which makes holding inflation at any given level very much harder.
The second case for a higher target avoids this slippery slope. It says, regardless of current conditions, that inflation of 2% is too low. If the target were a bit higher – not a lot higher – it would better serve the economy. The remaining overshoot of inflation should therefore be tolerated, indeed welcomed.
This view asks, what’s so special about 2%? Few think the “price stability” part of the Fed’s mandate requires zero inflation. What’s needed is inflation low enough to leave economic choices unimpinged. Inflation shouldn’t be “salient,” as the jargon has it. A rate of 3% probably passes this test. And slightly higher inflation has further advantages. It lubricates the labor market by letting real wages adjust gently downward if needed without explicit nominal wage cuts. Most important, by keeping the Fed’s nominal policy rate a bit higher than it otherwise would be, it leaves more space to cut when necessary.
This matters more than it once did. Interest rates have trended lower in recent years, pushing the Fed’s usual policy rate closer to the so-called zero lower bound. A slightly higher inflation target would arguably give the Fed an extra percentage point of flexibility on the policy rate at little or no cost. And right now, the higher target would avoid the risk of recession caused by the Fed’s feeling obliged to keep tightening.
The argument is sound in principle – but I’m skeptical on the balance of costs and benefits. If the Fed changed the target to 3%, there’d be some loss of credibility no matter how carefully it explained the reasoning. That could easily outweigh the gain in flexibility. Expected inflation of 3% might well cloud economic choices significantly more than expected inflation of 2%. And if, as some argue, the secular decline in interest rates is going into reverse – thanks to demographic forces and/or higher public investment for defense and climate-policy purposes – the value of an added margin of monetary-policy flexibility will be that much less.
It would be better to ask more of fiscal policy. To be sure, the fiscal response to the pandemic and the Ukraine-related supply shock wasn’t timid – rather the opposite. It was bigger than needed and unduly prolonged. The Fed has had to raise interest rates as much as it did in part to offset this excessive fiscal stimulus.
To moderate the business cycle more effectively, fiscal policy should rely more on automatic stabilizers. It would help if unemployment benefits were made more generous and easier to take up. These and other cyclically sensitive safety-net programs should reside less with states (which are constrained by balanced-budget rules) and more with the federal government. Such changes would help public spending respond more forcefully to the ups and downs of the business cycle.
In addition, the US could follow the example of countries that have set up non-partisan fiscal councils to oversee budget policy. The Congressional Budget Office could be asked to go beyond reviewing the fiscal outlook and scoring alternative tax and spending changes, as it does at present, and recommend changes in the projected budget balance for counter-cyclical purposes. To cool partisan disputes, this recommendation could, by default, be neutral on the balance between taxes and spending – proposing equal parts higher spending and tax cuts during slowdowns, and spending cuts and higher taxes during booms.
Meantime, the Fed’s job isn’t getting any easier. If inflation settles in at more than 2%, Powell and his colleagues will have to weigh the case for higher rates against the risk of recession and sudden financial instability. This dilemma could lead them to cast indefinite tolerance of inflation above 2% as no more than patience in hitting a supposedly unchanged target. They could even come to believe it. Cognitive dissonance meets central banking might prove to be the line of least resistance. But it wouldn’t be a smart or lasting solution.
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