Inflation Targeting and the rationale behind the two percent number
Speaking at the Boston FRB conference on October 14th, Fed Chairwoman Janet Yellen indicated that Fed officials are considering the benefits of running a “high pressure economy.” This sparked speculation that the central bank would allow its inflation target to temporarily exceed 2% as the labor market and aggregate demand improve.
The Fed’s dual policy mandate calls for the central bank to maximize employment and maintain stable prices. The central bank has designated a target of 2% as its inflation goal, but has not identified a policy target for employment levels. Optimal employment levels change over time given the cyclicality of labor markets, so it makes sense to keep a moving target for the labor market. But why did the Fed choose to specify an explicit 2% inflation target?
This week, we will take a closer look at the reasons behind the Fed’s 2% inflation target. We will also review the historical data and academic research that support this optimal level of price increases.The Fed and Inflation The Federal Reserve Act established the Fed in 1913 with the primary purpose to issue dollars and Fed notes as legal tender. Over time, the Fed has maintained control over the money supply through its power to create credit with fed funds rate changes and reserve requirements, even though the Treasury now issues dollars. Additional Fed responsibilities now include acting as the lender of last resort, supporting financial market stability, moderating long-term interest rates, maximizing employment and stabilizing prices. The last two are known as the Fed’s dual mandate. Although supporting economic growth is not one of the Fed’s explicit targets, its dual mandate is designed to aid long-term economic growth.
Under the gold standard, the central bank’s effectiveness was limited as the supply of money was limited by mining activities and inflation was determined by the intersection of money supply and demand. The Fed, like any other major central bank under the gold standard, could alter money demand by changing the amount of credit available on the market through its open market operations, but it did not have an effect on inflation.Although the Fed was established in 1913, its independence and effectiveness were limited by political constraints as the Treasury Secretary and Comptroller of Currency both sat on the Fed’s governing board. These two positions were removed from the Fed in 1935, but the Treasury could still ask the Fed to maintain low interest rates for political reasons as it did during WWII and the Korean War. Inflationary pressures were building during the Korean War period, and the Fed was torn between fulfilling the Treasury’s request of keeping interest rates low in order to finance the war effort and controlling inflation. The Treasury-Fed Accord of 1951 established the Fed’s true independence by removing its obligation to monetize the Treasury debt at a fixed rate.Controlling inflation became crucial following a period of hyperinflation in the 1970s. Inflation was brought under control under Chairman Volcker’s monetary policies, although the ongoing political changes of de-regulation and globalization played a major role in easing supply-side price pressures.Under Chairman Greenspan, investors suspected that the Fed was targeting an implicit inflation level, but it was not until January 23, 2012, that the Fed designated the headline Personal Consumption Expenditures (PCE) index as its main benchmark interest measure and Chairman Bernanke announced the explicit inflation target of 2%. The PCE measures price changes in the consumption sector of GDP, thus it changes with consumption patterns. We note that this is a longer term target, meaning the Fed is not looking for the PCE to hit 2% every month but, over time, it should trend toward 2%. HInflation Targeting
