2% Inflation Changes Everything

One can think of the past 100 years of US history as featuring three macro regimes:

1. Commodity money, with alternating periods of rising and falling prices.

2. Unanchored fiat money, with rising and falling inflation rates.

3. 2% inflation targeting.

Both transitions occurred gradually, so it’s not possible to assign precise dates, but 1940 and the early 1990s are plausible estimates.Here is the CPI inflation rate since 1913:

The Fed has a flexible

target, where it does not try to achieve precisely 2% inflation each year.In addition, they target the PCE price index, not the CPI.Thus if oil prices rise sharply, they generally allow the CPI to rise modestly above 2%, for a time.Here’s the core PCE inflation rate, but only since 1930:

Over the last 25 years, core PCE inflation has fluctuated in a tight range, from a high of 2.28% at the peak of the housing boom (2006) to a low of 1.16% in the depths of the Great Recession (2009.)Even that overstates the actual variation in non-food/energy prices, as core inflation is still somewhat affected by oil prices (think airfares, freight charges, etc.)

Many people focus on how the Fed often misses its 2% target, or treats it as a ceiling, and those are important issues.But doing so risks overlooking more important trends.Thus if the Fed were to treat 2% as an inflation ceiling, one might think of them as actually targeting inflation at something like 1.6% or 1.8%.I’m not sure that’s true, but even a 1.6% inflation target would have important implications.

The transition away from commodity money that begins to show up in the data after 1940 was essentially complete by 1968, at which time macroeconomics had to be reinvented.With fluctuating inflation expectations, we needed new ideas such as the Natural Rate Hypothesis and the Taylor Principle, which were not required under a commodity money regime with roughly zero percent expected inflation.

The current regime of 2% inflation targeting calls for another reinvention of macro.I’m not sure people have fully grasped how much everything changes under inflation targeting.Consider this recent comment by Tyler Cowen:

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Gary Anderson 3 months ago Contributor's comment

Trump wants to live in a world of inflation, where his debts decline in value. He would like to break the new normal. It is part of his policy to break the new normal. How much insanity he applies to the goal is what monetarists can talk about. It is politically advantageous to take on the new normal even if could have dreadful economic consequences.