How many times have we heard from central bankers that a 2% inflation rate is ideal? That monetary policy should be set at all times with that goal in mind? No doubt to the surprise of many readers, this target was adopted only in 2012 by the Federal Reserve; subsequently, it has become standard policy throughout the industrialized world. In a statement issued in September of 2012, the Fed stated:

“The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate. “[1]

The Fed clarifies its position further when it states that “the inflation target is meant to be reached over a longer period of time; inflation doesn’t have to be 2 percent all the time”. Former Chairperson, Janet Yellin, often stated that the FOMC expects inflation to reach the 2% target “in the medium term” without specifying how long that term would be. More importantly, the central banks within the last two years adopted a policy of “normalizing” rates; that is, setting a goal of higher short -term rates and a positive sloping yield curve.  Normalization would signify that economic growth had returned and that the 2% inflation target was being met consistently. The Governor of the Bank of Canada refers to bringing the economy “home” when the Canadian economy is operating at its full growth potential without inflation exceeding the target.

Alas, it is now more than 10 years since the 2008 crash and 7 years since the Fed adopted the 2% target, yet core inflation continues to fall short in the United States, the EU, Japan, and China--- essentially, worldwide. Not only have these economies come up short with regard to the inflation target, there has been no systematic large increase in total demand. Employment growth has been achieved without any wage inflation.  This creates a real dilemma for both the Fed and the European Central Bank in trying to wind down their respective unconventional monetary policies. Moreover, the prospects of an economic slowdown worsen the situation as there are calls now for rate cuts and for a halt to unwinding bond-buying programs. Abandoning a policy of gradual rate increases puts the bankers further behind the eight-ball with respect to normalization.

A long-time critic of Fed policy, Professor Brad De Long of UC Berkeley has advocated dropping the 2% target, citing that “the problem is not the 2%/year target, but rather pressure on the Federal Reserve 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.”[2]

De Long would like to see the Fed revert to the way policy was made in the 1990s without an explicit inflation target. At that time, the Fed worked the inflation results within the mix of data involving employment and various measures of output in setting the Fed funds rate. This approach provided more flexibility in establishing rates since it did not contain any specific hard inflation number that would dictate a  policy change. It seems that too much is riding on whether the inflation target is being reached or not.

[1] Federal Reserve, Statement on Longer-Run Goals and Monetary Policy Strategy Adopted effective January 24, 2012; as amended effective January 26, 2016

[2] My Sections: As Delivered: Fed Up Rethink 2% Inflation Target Blue-Ribbon Commission Conference Call