In order to reduce the inflation rate, the Federal Reserve has raised interest rates six times this year. The current inflation rate is 7.7%. The Fed believes that the ideal inflation rate is 2%. But how do central bankers decide that 2% is the ideal inflation target and not some other number?
That’s the question some Fed critics are asking. Bank of America was the latest bank to weigh in on the matter on Friday, bluntly saying: “There’s nothing special about a 2% inflation target.”
The Fed is not the only central bank with a 2% inflation target. Several countries have set the same target, which seems to further confirm that the 2% inflation target is perfect.
However, Bank of America took a different view, saying the Fed may be reluctant to adjust its 2% inflation target to other numbers because it would damage its credibility.
“Adjusting targets at the first serious test would undermine the central bank’s credibility and raise real fears of an economic downturn,” wrote Ethan Harris, global economist at Bank of America.
The Fed’s 2 percent inflation target was officially adopted in 2012. But the Fed and other central banks informally used this inflation target during the high-inflation years of the 1970s and 1980s. Bank of America said the target provides policymakers with a “cushion” that gives them room to cut rates during a recession, while also largely removing the risk of deflation.
“Assume that the actual neutral policy rate is 2 percent, and that underlying inflation rises to, say, 3 percent during the boom,” Harris wrote. Then, to tighten policy, the central bank would raise the policy rate above 5 percent. If and when the next recession comes, they can cut rates by more than 5% before they hit zero. By historical standards, such a buffer appears adequate. “
Still, there is little indication that 2% is the “sweet spot,” Harris said.
“The evidence shows that the additional costs of a stable 4% inflation rate compared to a stable 2% inflation target are very small. Whichever inflation target is set, the economy will adapt to that.”
Harris also argued that a 2 percent inflation target would not necessarily “satisfy” the central bank’s objective of maintaining price stability, referring to the Fed’s two main goals: ensuring maximum employment and maintaining price stability.
If inflation holds steady at 3%, the Fed may compromise or give itself more time (although there is no clear deadline) to achieve its 2% inflation target, BofA said. A mild recession could bring inflation down to 3%, after which the Fed could gradually lower inflation to 2% — similar to what happened in the 1980s and 1990s, BofA said.
Barry Sternlicht, CEO of private investment firm Starwood Capital Group, and prominent economist William Spriggs were previously interviewed by Fortune magazine Still, the Fed’s obsession with its 2 percent inflation target risks tipping the economy into recession, Shi said.
“The 2 percent inflation target is something that can be changed,” Spriggs said. “It’s not a result of economic modeling that says a 2 percent inflation target is the ideal inflation target.”
Sternlichter, who has blasted the Fed for using lagged consumer price index data that he says doesn’t show real-time inflation, has criticized the 2 percent inflation target.
“I think a 2 percent inflation target is somewhat arbitrary,” Sternlichter said. “Could the inflation target be 3 percent or 4 percent? It doesn’t matter 3 percent or 4 percent.”
He added: “I think 2 per cent might look like a good number as an artificial target. But it’s so close to zero. The problem is that when you’re chasing a 2 per cent inflation target, inflation is easy Down to -2%. You could be in a deflationary world with no demand and too many commodities.”
Regardless, Harris suggested the Fed wait until inflation is under control before making changes to its 2 percent inflation target. Then, he said, “there will be far fewer concerns about a lack of credibility or an economic downturn.” (Fortune Chinese Website)
Translator: Zhong Huiyan-Wang Fang
US Federal Reserve Chairman Jerome Powell.
KYODO NEWS—GETTY IMAGES
The Federal Reserve has raised interest rates six times this year in its effort to lower inflation—currently at 7.7%—to what it considers to be the ideal level of 2%. But how did the central banks decide that 2% is ideal rather than some other number?
It’s a question several Fed critics have raised. On Friday, Bank of America was the latest to weigh in on the matter, saying bluntly, “There is nothing special about 2%.”
The Fed has company in its 2% inflation target. Several countries have the same target, seemingly giving more confirmation that 2% is perfect.
Bank of America, however, has a different take, saying that the Fed could be reluctant to adjust its 2% target to some other number because it would undermine its credibility.
“Moving the target the first time it is seriously tested undercuts central banks’ credibility, raising real concerns about a slippery slope,” Bank of America’s global economist, Ethan Harris, wrote.
The Fed’s 2% target was officially adopted in 2012. But the Fed and other central banks had used it more informally amid the high inflation in the 1970s and 1980s. The target has provided “buffers” for policymakers by leaving room to cut interest rates during a recession while also largely eliminating the risk of deflation, BofA said.
“Suppose the neutral real policy rate was 2% and underlying inflation increased to, say, 3% during a boom,” Harris wrote. “Then to make policy restrictive the central bank would raise the policy rate to above 5%. the next recession came, they would be able to cut rates by more than 5% before hitting zero. By historic standards, that seems like an adequate buffer.”
Still there’s little to suggest that 2% is the “optimal target,” Harris said.
“The evidence is that steady 4% inflation imposes very small additional costs compared to steady 2% inflation. Either way the economy adapts.”
Harris also argued that 2% doesn’t necessarily “satisfy” the notion that central banks must maintain price stability, referring to the Fed’s two primary goals of ensuring maximum employment and maintaining.
If inflation stabilized at 3%, the Fed may compromise or give itself more time (although there’s no clear deadline) to reach its target, BofA said. A mild recession could drive inflation down to 3%, after which the Fed could reduce inflation to 2% over time—similar to what happened in the 1980s and 1990s, BofA said.
Nonetheless, the Fed’s obsession with its 2% target risks pushing the economy into a recession, Barry Sternlicht, CEO of private investment firm Starwood Capital Group, and prominent economist William Spriggs, previously told Fortune.
“There’s nothing written in stone that says inflation is supposed to be limited to 2%,” Spriggs said. “That target was not the result of an economic model that says 2% inflation is the ideal inflation.”
Sternlicht, who has slammed the Fed for using lagging numbers—measured by the consumer price index—that don’t actually show what’s happening with inflation in real time, criticized the 2% target.
“I think the number 2% is kind of arbitrary,” Sternlicht said. “And could it be 3% or 4%? That would be fine.”
He added: “I think 2% as an artificial target may seem like a nice number. But it’s so close to zero. And the problem is, as you go to 2%, you could easily go to minus 2%. You could go into a deflationary world where there’s no demand and too many goods.”
Whatever the case, Harris suggested that the Fed wait until inflation is under control to make any changes to its 2% target. At that point “there would be much less concern about a lack of credibility or slippery slope,” he said.
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