The Assumptions Behind the Federal Reserve’s Choice of 2% per Year Were Erroneous

A question I will never ask any Federal Reserve policymakers— not in public, not in private. They do not need their elbows jiggled in this way:

The decision by the Federal Reserve in the mid-1990s to settle on a 2% per year target inflation rate depended on three facts — or, rather, on three things that were presumed to be facts back in the mid-1990s:

  1. That the long run Phillips curve was vertical even with an inflation rate averaging 2% per year, so that there was no production or employment cost of such a target.

  2. That the safe real interest rate would be positive and significant, so that a 2% per year inflation target would not entail disturbingly low levels of nominal interest rates that might lead to instabilities in velocity.

  3. That shocks to the economy would be small, so that the Federal Reserve would never seek to compensate with an interest-rate reduction in the range of 5% or more.

We now know that all three of these were and are false.

The easiest way to fix this problem would be to revise the Federal Reserve Act — perhaps to add “healthy rate of nominal wage growth” to the list of Federal Reserve monetary policy objectives.

March 24, 2015

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