February 05, 2023
Everyone recognizes that inflation has slowed sharply from its peak in the spring of 2022. The question often asked is whether the inflation rate has dropped to the Fed’s 2.0 percent target. This requires a bit more careful thinking than it has received.
Before directly addressing this issue, let me briefly deal with a slightly different point. Many people have called for raising the Fed’s inflation target to 3.0 percent or even 4.0 percent. I think these higher targets would be fine. For my part, I have never been a big fan of the 2.0 percent target.
In fact, I would be fine if the Fed just went back to saying that it was committed to price stability as an undefined concept. But I do have to say, if it sets a target, and then changes it any time it seems difficult to achieve, then the target doesn’t have much meaning. For this reason, in my view, if the Fed is going to change its target, it should be done after it has brought inflation down to the 2.0 percent target.
But I raise this issue, just to be clear that I am not talking about changing the target. Instead, I am asking about what a 2.0 percent inflation target means.
Chair Powell, and his predecessor Janet Yellen, were both explicit in saying that 2.0 percent is meant as an average inflation rate, not a ceiling. This meant that we would have periods below and above the 2.0 percent target.
In the years leading up to the pandemic, the inflation rate was consistently below the 2.0 percent target. In the decade from the 4th quarter of 2009 to the 4th quarter of 2019, the inflation rate in the core personal consumption expenditure deflator averaged 1.6 percent. While the Fed presumably would have liked to have seen somewhat more rapid inflation over this decade, the gap between the 2.0 percent target and the actual inflation rate was not viewed as some sort of crisis or major failing of Fed policy.
This matters in the current context, because it is entirely possible we will see the inflation rate drop to a pace close to 2.0 percent, but remain somewhat above this level. The question then is how the Fed should view an inflation rate of say, 2.5 percent?
Obviously, 2.5 percent is above 2.0 percent, but if we envision 2.0 percent as an average, and there is no reason to believe that the inflation rate will rise from 2.5 percent, then it is hard to see why the Fed should be any more concerned about an inflation rate is 0.5 percentage points above its target than it was in the last decade about an inflation rate that was at times 0.5 percentage points below its target.
Inflation can move unpredictably, as we have seen, and a 2.5 percent inflation rate means there is little room for a rise without the Fed having to be worried, but there seems little harm in waiting. After all, what is the logic in saying that the Fed should deliberately slow the economy early, to lessen the risk that it may have to slow the economy at some point in the future?
At this point, this discussion is hypothetical. Maybe the inflation rate won’t slow to the point where this issue arises. Alternatively, if we get enough good news on rent, and goods’ prices keep falling, maybe inflation will be below 2.0 percent. In any case, it is worth a little thinking now about what a 2.0 percent target means. Based on the statements of the last two Fed chairs, it should not mean that inflation actually has to fall below 2.0 percent.