A Critique of Proposals to Raise the Fed’s Inflation Target
During the last seven years, the unemployment rate fell from 10 percent to less than 5 percent, but policymakers say that there is still an underutilization of labor resources. Why? Because inflation is below the Federal Reserve’s 2 percent target and GDP is below official estimates of potential GDP. The recommendation is to increase the Fed’s inflation target from 2 to 4 percent.
This narrative should be ignored for at least three reasons. First, raising the inflation target can damage the Fed’s credibility and the nominal anchor for our fiat money standard. Second, there is published evidence that a 2 percentage point increase in the inflation target would cause important welfare losses. Third, the idea that lower interest rates lead to higher inflation and more real growth is not supported by sound theory or U.S. data following the Volcker monetary policy reforms in 1979. That idea was discarded during the high inflation and high unemployment of the 1970s, but reemerged after monetary policy became credible in the 1980s. Yet, its reemergence has led to an environment during the 2000s in which interest rates have been kept too low for too long, spawning continued speculative behavior in housing and derivative markets.