What’s Wrong With the 2 Percent Inflation Target: False precision can lead to dangerous policies.

Paul Volcker’s new book,KEEPING AT IT – The Quest for Sound Money and Good Government, should be an interesting read.

In an extract from the book, he questions the 2% inflation target obsession:

In 1996, Federal Reserve Chairman Alan Greenspan had an exchange with Janet Yellen, then a member of the Fed’s Board of Governors, that presaged a major — and, I think, ill-advised — change in the central bank’s approach to managing the economy.

Yellen asked Greenspan: “How do you define price stability?” He gave what I see as the only sensible answer: “That state in which expected changes in the general price level do not effectively alter business or household decisions.” Yellen persisted: “Could you please put a number on that?”

Since then, under the chairmanship of Ben Bernanke and then under Yellen, Alan’s general principle — to me entirely appropriate — has been translated into a number: 2 percent. And more recently, a remarkable consensus has developed among central bankers that there’s a new “red line” for policy: A 2 percent rate of increase in some carefully designed consumer price index is acceptable, even desirable, and at the same time provides a limit.

I puzzle about the rationale. A 2 percent target, or limit, was not in my textbooks years ago. I know of no theoretical justification. It’s difficult to be both a target and a limit at the same time. And a 2 percent inflation rate, successfully maintained, would mean the price level doubles in little more than a generation.

I do know some practical facts. No price index can capture, down to a tenth or a quarter of a percent, the real change in consumer prices. The variety of goods and services, the shifts in demand, the subtle changes in pricing and quality are too complex to calculate precisely from month to month or year to year. Moreover, as an economy grows or slows, there is a tendency for prices to change, a little more up in periods of economic expansion, maybe a little down as the economy slows or recedes, but not sideways year after year.

Yet, as I write, with economic growth rising and the unemployment rate near historic lows, concerns are being voiced that consumer prices are growing too slowly — just because they’re a quarter percent or so below the 2 percent target! Could that be a signal to “ease” monetary policy, or at least to delay restraint, even with the economy at full employment?

Certainly, that would be nonsense. How did central bankers fall into the trap of assigning such weight to tiny changes in a single statistic, with all of its inherent weakness?

He goes to history and discusses how RBNZ first started inflation targeting and then the world copied it.

 

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