Although the Federal Reserve has not set a formal inflation target, policymakers generally agree that a rate of inflation around 2 percent or slightly less is acceptable.
Participants in the Federal Open Market Committee (FOMC), i.e., the Board of Governors members and the presidents of the Federal Reserve Banks, forecast how prices of goods and services purchased by individuals (also known as personal consumption expenditures, or PCE) are expected to change in the long run four times a year. The rate of inflation that the FOMC believes is most consistent with stable prices over the long term is the longer-run inflation projection. So that an inflation rate that is neither too high nor too low is maintained, the FOMC can then implement monetary policy. If inflation is too low, the economy may be in danger of experiencing deflation, which is a condition where prices and possibly wages are falling on average and is linked to extremely weak economic conditions. It is less likely that the economy will suffer from harmful deflation if the economy weakens when there is at least a modest level of inflation.
The projections for PCE inflation made by FOMC members for the longer term as of June 22, 2011 ranged from 1 5 percent to 2. 0 percent.
Why Central Banks wish to keep inflation at 2%
A higher inflation rate has various costs to the economy
- High inflation can create uncertainty and confusion for firms. In the long run, lower growth may result from less investment due to rising prices and raw material costs.
- When inflation is above 2%, inflation expectations will rise and it will be harder to reduce inflation in the future Keeping inflation less than 2% will keep long-term expectations low.
- Inflation of over 2% may indicate the economy is over-heating and this can lead to a boom and bust type of economic cycle
- If inflation is higher than that of your competitors, exports will be less competitive and the exchange rate will depreciate.
- Menu costs of changing prices.
Why do we target inflation of 2% rather than 0%?
Inflation of 0% is close to deflation, and deflation imposes a different type of cost on the economy Therefore inflation of 2% has certain benefits:
- It allows prices and wages to adjust
- It avoids the risk of deflation. Deflation is potentially damaging becauseIncreases the real value of debt. Consumers may be less likely to spend because they anticipate further price reductions. Additionally, since negative interest rates are not possible, it may render monetary policy ineffective.
The case for a higher inflation rate target
The optimal inflation rate is a subjective concept. According to some economists, there are instances where Central Banks may need to permit higher inflation (e.g. g. up to 4%).
graph source: ONS
Reasons higher inflation (3 or 4%) may be necessary
- Inflation can spike due to temporary cost-push factors. Inflation is influenced by volatile commodities like oil. Just before the 2009 recession, the UK had inflation of 5% %E2%80%93 which discouraged the Central Banks from cutting interest rates However, this inflation is only short-term and does not reflect excessive demand in the economy. In other words, monetary policy must distinguish between short-term inflationary increases and long-term increases in excess demand.
- Higher inflation rate gives more room for manoeuvre. Some economists argue that a target of 2% gives monetary policy too little room for manoeuvre E. g. during the slow economic recovery from the 2009 recession %E2%80%93 inflation fell below the 2% target, but cuts in interest rates were ineffective in boosting demand If we had a higher inflation target of 3 or 4%, we could have had more expansionary monetray policy %E2%80%93 leaving central banks more room for manoeuvre and therefore less need to rely on large budget deficits See: Interview with Oliver Blanchard from the IMF.
- Cost of unemployment. Inflexible targeting inflation of 2% could lead to a trade-off of lower economic growth and higher unemployment Higher unemployment has a higher welfare cost than moderate inflation. A high unemployment rate causes poverty, resource waste, and increased government borrowing.
This demonstrates that despite interest rates being zero, UK inflation was above target. 5% – because economic recovery was very weak. Interest rates would have gone up during a period of economic stagnation if the UK had been rigid about inflation.
- Low inflation expectations make monetary policy ineffective. Long periods of low inflation (such as the 1990s and 2000s in Japan and the 2010s in Europe) anchor inflation expectations at a very low level. As a result, nominal interest rates are low for an extended period of time. But, given the state of spare capacity, estimates of the desirable real interest rate are as low as -4% But, Central Banks do not go for negative interest rates. Therefore nominal interest rates o. 5% are too high causing slow recovery. Guido Tabellini of the ECB forum on Central Banking states.
- Prolonged low interest rates distort borrowing/saving. Low nominal interest rates can skew the market because they make borrowing extremely affordable and saving less appealing. Higher inflation rates would make it possible for interest rates to increase above current record lows and toward more “normal” levels. There is a danger with interest rates close to 0%, %E2%80%98zombie firms%E2%80%99 are able to keep borrowing to stay afloat
- Changed circumstances. When the US Federal Reserve set an inflation target of less than 2% in the 2000s, nominal interest rates were 6% Now nominal interest rates are 1. 75% – despite low unemployment. European interest rates are even lower, raising the possibility of a protracted liquidity trap. The FED believes it would be best to avoid this low inflation, low interest rate scenario given the current circumstances. (US Federal Reserve considers letting inflation run above target).
- Larry Ball quotes Paul Krugman as saying that the costs of moderate inflation are frequently overestimated.
- Larry Ball (2013) makes the case for an inflation target of 4% His main reasons are4% target would ease constraints on monetary policy during a liquidity trap and make economic downturns less severe The cost of 4% inflation is quite minimal, e. g. 4% inflation does not discourage investment, a bigger discouragement to investment is low growth
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FAQ
Is an inflation rate of 3% good?
Although the Federal Reserve has not set a formal inflation target, policymakers generally agree that a rate of inflation around 2 percent or slightly less is acceptable.
Why is 2% inflation the best?
Reasons for our inflation target of 2% Providing a safety margin against the risk of deflation and making sure monetary policy remains effective when it needs to respond to inflation that is too low Because there are restrictions on how far interest rates can be lowered, it is crucial to have a safety margin against deflation.
Is inflation rate of 2% good?
The Government sets us a 2% inflation target To keep inflation low and stable, the Government sets us an inflation target of 2% This helps everyone plan for the future. It is challenging for businesses to set the appropriate prices and for consumers to plan their spending if inflation is too high or fluctuates a lot.
What inflation rate is too high?
Generally speaking, the Federal Reserve strives to maintain what it calls a healthy inflation rate of around 2% over the long term 2 A rate of inflation higher than 2% is considered high Not just a high inflation rate, but hyperinflation is an extreme form of inflation.