Central Banks should forget about 2% inflation

Jeff Frankel in this Proj Syndicate articlec questions central bank’s focus on 2% inflation when they have failed to achieve the target. He says the problem could be with inflation expectations which have hardly been around the 2% mark:

Despite years of monetary stimulus, inflation in the United States, Japan, and the eurozone continues to undershoot central banks’ 2% target. Rather than doubling down on their oft-missed goal, however, perhaps the Fed and other central banks should quietly stop pursuing it aggressively.


Most economists and central bankers, however, fear that their credibility is at stake, and remain fixated on the need to reach the 2% inflation target. In fact, a few economists even want to raise the target from 2% to 4%. One proposal popular among monetary economists is so-called price-level targeting, whereby the Fed would pledge to achieve future inflation that is one percentage point above the 2% goal for every year that it has already fallen short of that target.

But why should these more ambitious inflation goals be credible or achievable when policymakers have failed to reach even the 2% target? Instead, economists should ask why the standard measures of inflationary expectations, such as professional forecasts, have not risen much in recent years.

Perhaps the public’s expected inflation – a central element of economists’ models for a half-century – does not really exist. Or, to be more precise, it may not be well defined when prices are relatively stable. After all, most people pay little attention to the inflation rate when price growth is as low as it has been in recent years.

In a recent paper, Olivier Coibion, Yuriy Gorodnichenko, Saten Kumar, and Mathieu Pedemonte argue that households and firms generally do not have well-informed expectations of future inflation, and often do not know what the inflation rate has been in the recent past. Large policy-change announcements in the US, the United Kingdom, and the eurozone, the authors argue, seem to have only limited effects on the inflation expectations of households and firms. (In a separate paper, two of the authors argue that reading news coverage of the Fed’s Federal Open Market Committee meetings has little effect on American households’ inflation expectations.)

They point out that US households’ expected inflation rate has averaged around 3.5% since the early 2000s – well above the actual rate or professional forecasts. In addition, when they asked hundreds of top executives for their US consumer inflation forecasts over the next 12 months, some 55% said they did not know. Among those who offered an inflation forecast, the average, 3.7%, was again too high.

Moreover, studies in Germany, other eurozone countries, and New Zealand indicate that the public’s inflation expectations are similarly off-target elsewhere. At the same time, the authors say, some standard surveys of the public’s inflation expectations can produce misleadingly reasonable forecasts by “priming” respondents beforehand with a set of choices.

Former Fed Chair Alan Greenspan once defined price stability as “that state in which expected changes in the general price level do not effectively alter business and household decisions” – in other words, inflation is low enough that people don’t think about it in their daily lives. In today’s environment, therefore, policymakers should not be too concerned if the average person does not have well-informed inflation expectations.

Why, then, should central bankers keep banging their heads against the wall of a desired inflation rate? To be sure, monetary authorities should be transparent about their expectations for long-run inflation, as well as for real GDP growth and unemployment. Rather than doubling down on their oft-missed 2% target, however, perhaps the Fed and and other central banks should quietly stop pursuing it aggressively.


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