Over the next few days, we feature extracts from our macro-economist Bob Gay’s latest piece ‘Rethinking Price Stability’
Part I: Introduction & Origins of the 2% Target:
Central banks are not equipped to tackle the structural forces that underlie the deflationary bias of today’s global economy. The big issues are income inequality in both the developing and emerging economies, excess saving especially in East Asia, persistent trade imbalances, the human cost of rapid technological advances, and climate change. All these factors weigh on growth prospects and have undermined the effectiveness of monetary policy in achieving full employment. In short, ultra-generous monetary policies and negative real interest rates have had limited success in overcoming these structural obstacles to growth, and conversely, quantitative tightening has done little to impede growth, contrary to claims by the Trump Administration. Notwithstanding those limitations to policy effectiveness, the Federal Reserve is contemplating whether to change its framework for targeting inflation from a simple guideline of 2% per annum to something more aggressive. Unfortunately, no monetary elixir will fix what ails global growth.
The Origins of the 2% Target
The Federal Reserve’s current policy framework evolved from the Full Employment and Balanced Growth Act (aka ‘Humphrey-Hawkins’) that the US Congress passed in 1978 amidst both rising unemployment and growing inflation. Among other things, the Act mandated the Board of Governors to establish a monetary policy whose goals were to promote full employment and price stability and to sustain long-term growth. In addition to these general goals, the Act set specific targets for unemployment and inflation. Namely, economic policies were supposed to reduce unemployment to 4% for the working-age population and inflation to 0% by 1988. The latter target was inappropriate for several reasons including its proximity to destructive deflation and the tendency of most measures of inflation to have an upward bias, especially those measures using fixed expenditure weights such as the Consumer Price Index.
Recognising these shortcomings, Chairman Paul Volcker asked the question that would define Fed policy for the next 40 years: what is the measured inflation rate consistent with price stability? Although technical in nature, the question went to the heart of what monetary policy was supposed to do – namely, to maintain long-lasting price stability. In response, the Fed staff engaged with the Bureau of Labor Statistics to estimate the measurement bias in various price indices. As I recall, the BLS estimate upward bias for the CPI at 2 percentage points per annum, 1-3/4 percentage points for the PCE fixed weighted index, and 1-1/2 percentage points for the GDP deflator. These estimates became implicit long-term inflation targets until Ben Bernanke decided to make them explicit in 2003. I recently asked an FOMC member if he thought those biases had changed over the years and the answer was ‘no’. If not, then any new inflation target, in my opinion, should be reconciled with simple rationale for the inflation target of 2% that has been used with considerable success for more than three decades.