The Terrible Twos: Central Bank Inflation Targets

The March job numbers came in somewhat worse than most analysts had expected. The slower job growth was largely attributable to unusually bad weather in late February and early March, but most of the commentators seem to be missing this fact. Many are warning that the economy might be weaker than they thought.

These warnings from commentators are in fact good news. They are good news first because it is almost certainly true that the economy is weaker than these analysts thought. Many had been making silly pronouncements about a new American boom that was not based in any real understanding of the economy. It’s always best when the people who are determining economic policy have some idea of the actual state of the economy.

The other reason the warnings are good news is that they may slow down the Federal Reserve Board’s rush to raise interest rates. The business pages have become obsessed in recent months over the date at which the Federal Reserve Board will start raising the short-term interest rate it controls from the zero level it has been at for the last six years. There had been growing pressure on Fed Chair Janet Yellen and other doves to pull the trigger. The recognition of slower growth will help to alleviate the pressure.

It is important that people recognize the debate over the Fed’s interest rate policy is not an abstract academic exercise. The point of raising interest rates is to slow the economy and keep people from getting jobs. Higher rates have this effect by discouraging people from buying houses and cars, making mortgage refinancing less attractive, and reducing investment by companies and state and local governments.

The reason the Fed would want to keep people from having jobs is that it is worried that a strong labor market would lead to more rapid wage growth, which in turn would be passed on in higher prices. In other words, keeping people unemployed is a way to keep inflation under control.

The concern over inflation seems more than a bit bizarre given the current state of the economy. The core inflation rate (excluding food and energy prices) has been running close to 0.5 percentage points below the Fed’s 2.0 percent target. This means that even using this target as a guide we should want to see higher rather than lower inflation.

But before we give the Fed a green light to deliberately kill jobs it is worth asking about the merits of the 2.0 percent inflation target. The 2.0 percent inflation target did not come from God or even Congress. It was the invention of Ben Bernanke, Janet Yellen’s predecessor as Fed chair.

This fact is important because there is no reason that today’s Fed should feel bound by the views of a former Fed chair. While the other members of the Fed at the time supported Bernanke in opting for a 2.0 percent inflation target, this view put them at odds with the Fed’s prior practices.

For example, Alan Greenspan and Paul Volcker, in their combined reign of nearly three decades as Fed chairs, did not think it was appropriate to tie the Fed to a specific inflation target. They preferred the flexibility to respond to circumstances.

The history since the collapse of the housing bubble provides good grounds for thinking that a 2.0 percent inflation target is a bad idea as many prominent economists have argued. One of the problems of trying to use monetary policy to boost the economy is that a 2.0 percent inflation target does not provide very much room for effective monetary stimulus.

The way monetary policy boosts the economy is through low real interest rates. The real interest rate is the nominal interest rate (currently zero) minus the inflation rate. It is hard to push the nominal interest rate much below zero, which means that the real interest rate can only be as large as the inflation rate. If the inflation rate is 2.0 percent or less, then the best we can do is to have a negative real interest rate of -2.0 percent. In Europe and Japan, where the inflation rate has fallen to less than 1.0 percent, the real interest rate is less than -1.0 percent. This does not provide much of a boost to the economy.

By contrast, if the inflation rate was 4.0 percent and the nominal interest rate was zero, then we would have a real interest rate of -4.0 percent. That would provide far more of a boost to the economy.

To see this point, imagine that you could get a 4.0 percent mortgage on a house that you expected to rise in price by 2.0 percent a year.  Now suppose that you expected the house price to go up 4.0 percent every year. You would be much more likely to buy the home in the second case. The same logic applies to decisions made by tens of millions of individuals and businesses across the country.

This is why the 2.0 percent inflation target can be so harmful. It makes it far more difficult for the Fed to boost the economy out of a downturn like the one we have been experiencing.

The weak job numbers for March should be seen as opportunity to force the Fed to reshape its thinking on plans to raise interest rates. There is no reason it should be looking to slam on the brakes any time soon. Rather it should be doing everything in its power to try to sustain and increase the current rate of economic growth.

Originally posted at CEPR.Net.

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