Fed’s 2 per cent inflation target arbitrary

NEW YORK (Agencies): There’s rarely a convenient time for the Federal Reserve to openly debate whether its 2 per cent inflation target makes sense. This isn’t that time, but the Fed better get ready.

More urgent matters preoccupy the Fed right now. It is simultaneously stanching a crisis in the banking system while tightening financial conditions to squelch inflation. The central bank raised its benchmark Federal funds rate a quarter point to a range of 4.75 to 5 per cent. It also assured the markets that “the US banking system is sound and resilient”.

The last thing the Fed needs at this moment is further complexity in its public messaging. “We will get inflation down to 2 per cent, over time,” Jerome Powell, the Fed chair, said at a news conference.

Two per cent is supposed to be the sweet spot for inflation, low enough for consumer comfort but relaxed enough for the economy to flourish, according to Fed doctrine settled years ago. The Fed isn’t reconsidering it in public now.

Yet the inflation target is an important issue, one that scholars and Fed watchers are quietly discussing because it could become crucial soon. The Fed itself projects that inflation will drop to about 3.3 per cent by the end of this year and to 2.5 per cent next year. Well before that happens, it’s worth re-examining the 2 per cent target: how the Fed arrived at it, whether it still makes sense and whether current rules allow sufficient flexibility in decision making.

Inflation needs to come down, unquestionably. But with the financial tightening already underway, inflation may wane in a sustained way in the next few months. At that point, the cost in lost jobs and economic growth could be cruel and excessive if the Fed tightens further in an attempt to drive inflation down to 2 per cent, a target that is, after all, an arbitrary one.

Laurence Ball, a Johns Hopkins economist, reminded me of that in a conversation this past week. While Paul A. Volcker is now renowned for vanquishing inflation as Fed chair in the 1970s and 1980s, when he left office in August 1987, inflation was still above 4 per cent.

“If 4 per cent was good enough for Volcker,” Ball said, “it should be good enough for us.”