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Federal Reserve Considering Taking the Dangerous Step of Allowing Price Inflation to Climb Above 2% Target

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Via Economic Policy Journal

Federal Reserve Board Eccles Building, Washington D.C.

By Robert Wenzel

In the background, various Federal Reserve members have been promoting the idea that price inflation should be allowed to run “hot” above the current target 2% price inflation rate to “make-up” for recent low price inflation, but now, for the first time, we are seeing the idea featured in a high profile story.

Brendan Greeley, US economics editor for The Financial Times,
reports in a story that appeared on FT’s front page:

The Federal Reserve is considering introducing a rule that would let inflation run above its 2 per cent target, a potentially significant shift in its interest rate policy.

The Fed’s year-long review of its monetary policy tools is due to conclude next year and, according to interviews with current and former policymakers, the central bank is considering a promise that when it misses its inflation target, it will then temporarily raise that target, to make up for lost inflation…

If the Fed adopts this so-called “make-up strategy”, it would mark the biggest shift in how it carries out its interest rate policy since it began to target 2 per cent inflation in 2012.

These types of stories do not appear by accident.

The Fed is seeding the ground for the review which will call for higher price inflation.

It should be noted, however, that there is no reason for any price inflation target.

As former Fed Chairman Paul Volcker wrote in his memoir:

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 am sure the Fed is thinking about an inflation rate that climbs to around the 2.5% to 3.0% range.

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That’s what New York Federal Reserve President John Williams told me at “The Strategies for Monetary Policy” conference at the Hoover Institue this summer when I asked him about a higher target range:

I think that some of the worries around average inflation targeting is, are you going to aim for three or four percent during good times? In fact, at least, based on the historical experience, you’re talking about a relatively few tenths. Let me give you a concrete example. Last ten years, core inflation in the US has been running about 1.6% on average despite the worst recession of our lifetimes. So, that gives you an idea that even in that case, inflation, the miss on inflation isn’t that huge, even in that sense.

But, as I have pointed out in the EPJ Daily Alert, with this type of thinking, they are not going to get concerned about price inflation until it hits 3%, but this is going to be very late to the battle.

They are thinking that price inflation will only accelerate by a tenth here and a tenth there so they will have plenty of time to slow accelerating inflation. However, it is very possible that once price inflation gets going it could jump to the 5% range very rapidly. That’s what happened in 1950, 1974, 1979 (up to 10%) and 2008.

If price inflation hits 5%, the Fed would have to raise the Fed funds rate to around 6.5% to 7.0% to kill the price inflation—and that is not going to happen.

The idea of allowing price inflation to run “hot” is a very dangerous idea. Things on the inflation front could get out of control very rapidly once the acceleration starts.

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The Fed has no clue.


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