Against Higher Inflation

A better monetary policy wouldn’t set any inflation target. 

Does the U.S. economy need more inflation? A group of 22 progressive economists has written a letter to the Federal Reserve urging it to appoint a blue-ribbon commission to study whether the central bank should raise its target for inflation above its current 2 percent. Fed chairman Janet Yellen, in her press conference following the latest interest-rate increase, called it “one of the most important questions” facing the organization. 

The economists’ advice shouldn’t be rejected out of hand, but it should be rejected. They make some valid points in their diagnosis of the ills of the current monetary regime. But the Fed can and should address these problems without raising inflation. 

For most people it is probably puzzling that anyone should want inflation to rise. They consider inflation a hit to their standard of living and don’t want more of it. But the extent to which inflation reduces standards of living depends mostly on what drives it. If an oil embargo raises costs throughout the economy, it will indeed tend to raise prices and cut into real incomes. An inflation driven by the central bank’s creation of extra money, on the other hand, should increase prices and wages very close to proportionally. (We’re using the term “inflation” the way most people and economists do, as a rise in the general price level.) This kind of inflation is unpopular mostly because people assume that they have earned their inflated wages but resent paying inflated prices. 

Which is not to say such inflation is costless. If inflation is unpredictable, businesses and households will have difficulty making long-term economic plans — in part because it creates arbitrary wealth transfers. When inflation comes in higher than expected, the bank that provided your fixed-rate mortgage will take a bath; when it comes in lower, you will. Inflation also raises the burden of taxes on capital, since our laws do not adjust for it: It is possible to pay a capital-gains tax on an asset even when it has not appreciated at all in real terms. Then there are the costs of having to adjust prices to keep up with a constantly changing price level: what economists, thinking of the restaurant business as a good example, call “menu costs.” 

When inflation is both low and stable, however, these costs are manageable. Central banks the world over have converged on a 2 percent target rate for inflation during the last few decades partly as a matter of happenstance, but economists have generally considered 2 percent a reasonable number. The costs mentioned above would not rise much higher with year after year of 2 percent inflation than they would with year after year of 0 percent inflation. (And they would be lower still if our capital-gains taxes adjusted for inflation.) 

The slightly higher rate has a few advantages over the lower one. It can make economic transitions smoother. Employees are more hostile to wage cuts of 2 percent with 0 percent inflation than they are to stable wages with 2 percent inflation, even though these outcomes are economically identical. A little inflation therefore makes it easier for employers to lower labor costs by not giving pay raises rather than by laying people off. 

One of the other reasons central banks preferred 2 percent to 0 percent inflation is that it gave them more flexibility. During a recession, central banks usually cut interest rates in order to stimulate the economy. The higher the interest rate is at the start of the recession, the more they can cut it. Since interest rates are composed of both a real return to savings — the real interest rate — and compensation for expected inflation, a 2 percent inflation target will keep interest rates higher than a 0 percent one.

And that brings us to the case for an even higher inflation target. The supporters note that a higher inflation target would give the Fed even more room to maneuver. International comparisons bolster this case: Countries that have tolerated higher inflation over the past decade have fared better than we have. Australia had some of the same vulnerabilities we did before the Great Recession — a real-estate boom and a surge in household debt — and was more exposed than we were to swings in commodity prices. Yet its economy continued to grow during the crisis. It came into the crisis with a core inflation rate of 4 rather than 2 percent, which meant higher interest rates. Australian monetary authorities could thus cut interest rates more than we did. 

Israel did not avoid the recession, but it had a more robust recovery than we did. Higher inflation played a role there too, albeit a different one than in Australia. After Israeli interest rates fell close to 0 percent, monetary authorities allowed the inflation rate to go as high as 5 percent in 2009. Although this inflation eventually caused interest rates to rise, its immediate effect while interest rates were stuck near 0 percent was to push real interest rates deep into negative territory and thus spur more spending. 

The argument, then, is that both Australia and Israel did better than the United States during the crisis by tolerating higher inflation. Why not tolerate a bit more inflation here, the advocates say, through a higher inflation target? 

The proponents also argue that a higher inflation target is needed because real interest rates have been headed downward for decades. Many economists, especially those who want a higher target, say that slowing productivity growth and an aging population are bringing real interest rates down. 

Over the decades before the Great Recession, inflation averaged 2 percent and the real interest rate roughly 3 percent, making for an interest rate a little above 5 percent. These days it is often estimated that the economy can sustain real interest rates near 1 percent. To get interest rates above 4 percent again would therefore require raising the inflation target to the 3 to 4 percent range. 

These arguments for a higher inflation target are reasonably strong if you accept the premise that keeping inflation stable should be the Fed’s principal task in the first place. There is, however, a superior alternative. That alternative would stabilize the growth of nominal spending: the total amount of dollars spent throughout the economy. The growth rate of nominal spending equals the sum of the rates of inflation and of real economic growth. (In 2015, for example, inflation ran at 1.2 percent and the economy grew by 1.6 percent in real terms, so nominal spending grew by 2.8 percent.) Under a level target for nominal spending, the Fed would commit to keeping total spending growing at a steady rate, say 4 percent. It would commit, further, to correcting for any failure to hit the target. If nominal spending grew by 4.5 percent one year, that is, the Fed would shoot for 3.5 percent the following year. 

This policy would capture the benefits of inflation targeting, such as facilitating long-term economic planning by households and businesses. It would arguably serve that purpose a little better than inflation targeting, since most debt and labor contracts are written in nominal terms. It would be compatible with keeping inflation low and fairly stable. If the economy’s real growth rate over the long term averages 2 percent, then hitting a 4 percent nominal-spending target implies achieving a 2 percent average inflation rate too.

A key difference between the two policies is that a nominal-spending target would allow inflation to fluctuate over the short term in response to movements in productivity. A negative supply shock, such as the oil embargo we mentioned earlier, will push prices up and output down. A strict inflation-targeting central bank would try to keep prices from rising by raising interest rates — at the cost of harming an already weak economy. Something like that happened in 2008: Rising commodity prices led the Fed to refrain from cutting rates in the early months of the recession. A nominal-spending target would have had more tolerance for a short-run increase in inflation. 

A positive supply shock, on the other hand, will pull prices down. In that case, an inflation-targeting central bank, whatever inflation rate it has chosen, will be tempted to lower interest rates to keep inflation from falling. If it does it will overstimulate the economy. This appears to have happened in 2002–04, when a productivity boom made the Fed fear deflation and it responded by holding interest rates too low for too long. Under a nominal-spending target, on the other hand, the Fed would have allowed productivity to reduce inflation. 

A key argument for a higher inflation rate, you will recall, is that real interest rates have declined as the economy’s productive potential has. But those interest rates can move rapidly. The San Francisco Fed uses a measure of the “natural” real interest rate — the rate justified by the economic fundamentals — that fell from 2.12 percent at the end of 2007 to 0.34 percent a year later. That was a rapid decline tied to the business cycle. There is no reason in principle that the real interest rate could not rise rapidly as well. If it did, the argument for a higher inflation target would go into reverse: A lower one would be justified. But changing the target with every change in productivity would nullify the advantage of stability.

A nominal-spending target, on the other hand, would not need to alter in response to changes in productivity. Changes in productivity would change the composition of nominal spending — the more productivity grows, the higher the ratio of real economic growth to inflation — but not the total. 

As for Australia and Israel, it’s worth noting that in both countries nominal spending grew at a steady pace. Spikes in inflation may have been helpful, that is, only insofar as they enabled the stabilization of nominal spending. 

We have not yet mentioned one peculiarity of the argument for a higher inflation target. Even though Yellen signaled her openness to that argument, we have actually been below 2 percent inflation for eight years — which is to say, before, during, and after the Fed’s formal adoption of that target. In some quarters the Fed’s failure to hit its target has led to doubt about whether the Fed even has the capacity to raise inflation any more, in which case its capacity to increase nominal spending would also have to be questioned. This doubt is unjustified: The Fed has repeatedly refrained from taking steps that would have increased inflation further, and taken steps that reduced it. 

A nominal-spending target would make for a stabler macroeconomic environment than an inflation target, for the reasons we have described, and would not require enduring higher inflation rates on average. But no target is going to work as well as it could if the Fed is unwilling to take it seriously. And no blue-ribbon commission is going to supply that willingness.