Why the Fed Should Rethink Its 2%/Year No-Lookback Inflation Target

Conference call today at 9:00 PDT/noon EDT on why the Federal Reserve would be very smart to abandon its 2%/year no-lookback inflation target for a less destructive policy framework. The call is to be moderated Shawn Sebastian. Then Josh Bivens will summarize his short whitepaper: “Is 2% Too Low? Rethinking the Fed’s Arbitrary Inflation Target to Avoid Another Great Recession” http://www.epi.org/publication/is-2-percent-too-low/. Jason Furman will talk about the evidence for the fall in the equilibrium Wicksellian neutral rate of interest and the implications of that for optimal monetary policy. I come next. Joe Stiglitz wraps up. And then questions from reporters.

My task is to set out what the arguments on the other side are—and why we do not find them convincing:

I hear four arguments for not changing the 2%/year inflation target, even though pursuing that target found us in a situation where monetary policy was greatly hobbled in its ability to manage the economy for a solid decade. And, as best as I can evaluate them, all four of these arguments seem to me to be wrong. They are:

1. The Federal Reserve, even at the zero lower bound, has powerful tools sufficient to carry out its stabilization policy tasks (Cf.: Mankiw and Weinzierl (2011) https://scholar.harvard.edu/files/mankiw/files/exploration_of_optimal.pdf), so moving away from 2%/year as a target is not necessary. The response is: This leaves begging the questions of why, then, employment has been so low over the past decade, and why production is still so low relative to our circa-2007 expectations.

2. The problem is not the 2%/year target but rather pressure on the Federal Reserve: pressure from substantial numbers of economists and politicians practicing bad economics and motivated partisan reasoning. (As an example, somebody sent me a video clip this week of the very smart Marvin Goodfriend half a decade ago, arguing that faster recovery required the Fed to hit the economy on the head with a brick to make people more confident in its willingness to fight inflation http://www.bradford-delong.com/2017/06/on-the-negative-information-revealed-by-marvin-goodfriends-i-dont-teach-is-lm.html.) The response is: This ignores the Fed’s long institutional history of being willing to ignore outside pressure as it performs its standard monetary policy task of judging what appropriate interest rates are. Pressure only mattered when we got into “non-standard” monetary policies, which we needed to do only because the low inflation target had caused us to hit the zero lower bound.

3. At 2%/year, inflation is non-salient: nobody worries about it. A higher inflation rate would bring shifting expectations of inflation back into the mix, distract people and firms from their proper task of calculating real costs and benefits to worry about monetary policy, and make monetary policy management more complicated. The response is: But right now people and firms are “distracted” by the high likelihood of depressions that last longer than five years. That is a much bigger distraction than worrying about whether inflation will be 4%/year of 5%/year. And right now the zero lower bound makes monetary policy management much more complicated than it was back in the 1990s when the impact of Fed policy on inflation expectations was in the mix.

4. The Federal Reserve needs to maintain its credibility, and if it were to even once change the target inflation rate, its commitment to any target inflation rate would have no credibility. The response is: But the credibility you want to have is credibility that you will follow appropriate policies to successfully stabilize the economy—not credibility that you will mindlessly pursue a destructive policy because you think it somehow wrong to acknowledge that the considerations that led you to adopt it in the first place were wrong or have changed. As my friend Daniel Davies puts it in his One-Minute MBA Course: “Is a credible reputation as an idiot a kind of credible reputation one really wants to have?” http://crookedtimber.org/2006/11/29/reputations-are-made-of/

Over to you, Joe…