Rethinking the Fed's 2% Inflation Target: Spotlight On an Absurd Debate

Is the Fed's 2% inflation target too high or too low? That's the big debate now amongst central bankers.

The Wall Street Journal reports Policy Makers Rethink a 2% Inflation Target.

> From Ottawa to Oslo, policy makers have been considering whether that level of consumer-price growth, a Holy Grail for the world’s major central banks over the past quarter-century, is still relevant.

> The 2% target was always an arbitrary figure, some economists argue, and even if it was optimal two decades ago, that is no longer the case given deep changes that have since reshaped the global economy.

> Trouble is, it isn’t clear what inflation rate would be better. Dozens of academic studies that considered that question have produced answers ranging from 6% to less than zero, according to a survey published last year by Federal Reserve economist Anthony M. Diercks.

> “Whatever [inflation] rate was thought to be optimal in 2006 or before is now too low,” says Olivier Blanchard, a senior fellow at the Peterson Institute for International Economics in Washington, D.C., who has called for a 4% target.

> Factors such as aging populations, low economic growth and higher savings rates are working to push down the neutral interest rate, at which the economy is growing at a sustainable rate for the long run and inflation is stable. As a result, central banks run a greater risk of taking benchmark interest rates to zero or below when seeking to support growth.

Demographics

Logic would dictate that if demographics work to hold the inflation target lower, then the target ought to be lower not higher.

Lesson from Japan, ECB

Japan provides ample evidence of what happens to savers when the central bank holds down rates hoping for higher inflation. All Japan did was accumulate debt. Inflation went nowhere.

What good does it do to set a target when you struggle for decades in the case of Japan and one decade in the case of the ECB to hit your target?

Fundamentally, these are not even the correct question, but they do highlight the silliness of the discussion which is asinine on many levels.

Absurd Discussion, Multiple Levels

  1. Central banks do not even know how to measure inflation. Yes, they have there smoothed formulas etc. But the alleged "average" rate of inflation is "average" nonsense. Home prices are not in the CPI nor are asset prices in general. Central banks have not once in history spotted a bubble. Bernanke and Greenspan went out of there way to deny them. If you cannot spot bubbles, how the hell can you possibly know if interest rates are too high or too low?
  2. Central banks set inflation targets and fail to hit them, then make up excuses such a Janet Yellen's famous dissertations: 1) It's transitory and 2) the Phillips Curve isn't dead yet. This is despite the fact Fed studies show the Phillips curve is total nonsense.
  3. In practice, central banks do what they want, targets be damned. If the Fed wants to hike it will, if for no other reason than to have "ammunition" for the next decline. Group think is at work.
  4. Implicit in this discussion is the notion that real wages will rise. Alternatively, Blanchford and other economists failed to assume anything at all. Real wages, even nominal wages may barely rise, if at all.
  5. The BIS conducted a study of deflation and recessions over a long period of time. The BIS found that falling prices are not a problem except when accompanied by asset price deflation. Thus, despite all of the nonsense about 4% or even 6% rates, which by the way would crucify those on fixed incomes, there is nothing wrong with negative inflation.

BIS Deflation Study

For a discussion of the BIS study, please see Historical Perspective on CPI Deflations: How Damaging are They?

"Deflation may actually boost output. Lower prices increase real incomes and wealth. And they may also make export goods more competitive,” stated the study.

It’s asset bubble deflation that is damaging. When asset bubbles burst, bank loans become impaired and debt deflation results.

Central banks’ seriously misguided attempts to defeat routine consumer price deflation is what fuels the destructive asset bubbles that eventually collapse.

Meanwhile, economically illiterate writers bemoan deflation, as do most economists and central banks. The final irony in this ridiculous mix is central bank policies stimulate massive wealth inequality fueled by soaring stock prices.

It would behoove the Fed, Olivier Blanchard, and every other economist to take a look at Japan as well as the BIS study.

They Do What They Want

The Fed, Olivier Blanchard, BOJ etc, are not interested in reality. They are all interested in absurd theories that do not work in the real world.

Moreover, the Fed, BOJ, and ECB will all do what they want, targets be damned, with no regards to asset bubbles, demographics, or even a decent measure of what inflation really is.

I have a better way: Get rid of central banks, their bubble-blowing polices, charlatan economists preaching about inflation targets, and fractional reserve lending.

Related Articles

  1. Laughable FOMC Statements on Phillips Curve, Inflation Expectations
  2. Fed Study Shows Phillips Curve Is Useless: Admitting the Obvious

Despite the absurdity of it all, economists still place faith in models proven wrong. Nearly every week I see someone proclaim the Phillips Curve is about to work or is working again.

In reality, since the curve is totally random, it's bound to look as if it's working about half the time.

Height of Absurdity

Former Fed chair Yellen Wants Fed to Commit to Future Booms to Make Up for Busts

It never occurred to Yellen that the cause of busts is the easy-money boom that preceded them.

Challenge Still Unanswered

Meanwhile, my Challenge to Keynesians “Prove Rising Prices Provide an Overall Economic Benefit" has gone unanswered.

It cannot be answered because there is no benefit.

Mike "Mish" Shedlock

Comments (8)
No. 1-8
hmk
hmk

The govt is the main beneficiary of inflation as it erodes the value of their debt burden. This is why they deliberatly underreport true middle class cost of living numbers so they can hold interest rates low while maintaing a high debt load. Next comes the elinimation of cash so when they go to negative interest rates they can just debit your digital bank account. Sounds like a great game plan.

Sechel
Sechel

My first thought when the 2% target came out was Goodhart's law

flubber
flubber

Bottom line.....if you are a debtor, inflation is your friend. If you are a creditor, inflation is your enemy. I think the Fed thinks that at a 2% inflation rate, they can have their cake and eat a bit of it too.

thimk
thimk

the feds and other central banks roles are to keep the massive budgets of government funded.

Kinuachdrach
Kinuachdrach

As they say, if the only tool you have is a hammer, everything starts to look like a nail. Poor old Central Bankers think they are in charge of the economy -- all they have to do is monkey with money printing and interest rates and, Voila!, the real economy will hum along.

But the real economy is actually driven by innovation. What makes it hum is inventing things like the computer chip, GPS, smart phones, hydraulic fracturing, etc. Real things. Central Bankers can only mess up & distort the real economy, not stimulate it in any sustainable fashion.

killben
killben

"Despite the absurdity of it all, economists still place faith in models proven wrong. "

How else can the economists justify their existence? But for these models they might as well not exist...

Stuki
Stuki

Just imagine the uproar that would result in a real empirical science, like physics, if some government sponsored institution packed with middlebrows, were sitting around debating how much should ideally be added to the official meter every year.... Or perhaps the official kilo, to account for people's weight gain...

Yet this is what the manchildren in social "science" departments, and the institutions they then go on to desecrate with their idiocy, occupy themselves with. To the cheers of the baboons Jefferson so naively hoped would form the bulwark against government expansion and encroachment of God given, natural rights.

So now, we have central bankers seriously debating how much to debase, as in rob of real purchasing power, people every year. While other progressive inventions, like Planned Parenthood and the Chinese Communist party, debate how many children people should have. And every Tom, Dick and retarded Jane having mindless opinions about how many story houses, and how dense other people should live, in virtually every city in the West.

And yet those of us a bit higher up the evolutionary ladder, are supposed to be all up in arms, and happily handing over even more autonomy to these absolute idiots, over something as comparatively benign as a few genocidal Mullahs taking over and throwing the riffraff out.

Christian dk
Christian dk

Good point Mish

  • Inflation is only loss of purchasing power with wealth already saved up. 2 % inflations means losing your entire savings in 36 years, the rule of 72 / %. Exactly why real estate keeps going up and even faster when interest rates drop as you can borrow more against your 4 x earnings, 10 x in some places.