66065
Janet Yellen
World Economy

Fed Needs Better Inflation Target

On Friday, a group of economists published a letter urging the US Federal Reserve to consider a monumental change in policy: raising its target for inflation above the current 2%.
The letter said that inflation target helps define how much stimulus the Fed can deliver when it lowers interest rates to zero (a boundary below which the central bank has been unwilling to go). In a higher-inflation environment, a nominal Fed funds rate of zero results in a lower real, net-of-anticipated-inflation rate—the rate that economists typically see as most relevant for consumer and business decisions, Bloomberg reported.
If, for example, people expect inflation to be 3%, then a zero nominal rate translates into a negative 3% real rate—a full percentage point lower than the Fed could achieve if expected inflation were 2%.
Experience suggests that the Fed could use the added ammunition. During the most recent period of near-zero interest rates, the US unemployment rate remained above 5% for nearly seven and a half years (from May 2008 to September 2015).
Chair Janet Yellen has suggested that, if another recession takes the Fed to the zero lower bound, the unemployment rate might stay above 5% for close to five years. To put it mildly, these aren’t desirable outcomes.
The issue is all the more important because periods of zero nominal rates are likely to be more frequent. In a recent Brookings Institution paper, Fed staffers Michael Kiley and John Roberts conclude that changes in economic conditions—specifically, a lowering of the “natural” interest rate consistent with full employment and stable inflation—might require the Fed to be at the zero lower bound about 30% to 40% of the time.
All this argues for a higher inflation target. But that’s not the only change worth contemplating. The Fed should also consider adopting a time horizon for achieving its target—something many central banks do. Without such a benchmark, the Fed is free to undershoot (or overshoot) for many years at a time. This creates uncertainty that can weigh on economic growth.
Of course, there’s also a case against raising the inflation target. That’s why the more important part of the letter is its call for “a diverse and representative commission” to re-examine the monetary policy framework—a much more open and transparent approach than the Fed usually takes.

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