In 2016, I wrote a piece at mises.org highly critical of inflation targeting.
At that time the idea of a 2% inflation target was fast becoming mainstream. Since then it has become a routine yardstick for assessing economic policies.1 It was a hit with politicians, liberal economists, and borrowers around the world because with inflation running below that level in most major economies it was a license to keep printing money. And now, with inflation closing in on 2%, the easy money crowd has done exactly what I expected and trotted out phase II: the new target is to average 2%. In other words since we were below 2% for so long, a rise to 3% or 4% for a while is somehow desirable.
The 2%, one-size-fits-all rate, was probably chosen for the reasons above plus it was an innocuous sounding round integer, which level existed for a while during some past economic upswings. However, common sense dictates that one size doesn’t fit all. There are situations where zeroish inflation is appropriate, where healthy competition — internal and external — plus innovation and automation are rampant. On the other hand, during supply shocks, such as the oil crisis of the 1970s, higher than 2% must be tolerated to avoid disaster.
The scary thing is that inflation targeting involves deliberately inflating as a routine policy tool for managing the economy. This is a blatant departure from a central bank’s traditional duty to protect the purchasing power of a currency. In a massively indebted country, such as ours, downgrading this “sacred duty” multiplies the risk of instability. Nevertheless, the idea managed to work its way into mainstream thinking without scaring as many people as it should have.
Targeting may be short on economic merit, but it was brilliant as an easy to understand, reasonable-sounding mantra which could be chanted anytime the critics of excess ease appeared. I don’t think we will be so lucky if the Phase II averaging idea gains traction.
As the long slow recovery continues and the labor market tightens, the Fed is under pressure to bring interest rates back towards neutral and reduce its huge balance sheet. This is bad news for the easy money crowd. A lot of bills for the period of extreme ease will begin coming due. However, higher nominal rates with even higher inflation still equals low real rates: Eureka – averaging!
Meanwhile, everyone seems to be focused on the minutia of the business cycle while ignoring the elephant in the room. There are trillions upon trillions of dollars, dollar instruments, and dollar contracts all owned by parties who will get hurt by actual inflation or changes in expectations if we embrace the 3% or 4% ideas. Unlike 2%, these numbers are outside many people’s comfort zone, and the elephant could react badly.
What if the elephant refuses to sit still for the initial beating and then for unfathomable reasons refuses to believe that the government will have the will or ability to bring inflation back down to 2% after a year or two? When the central bankers were resuscitating the world economy with super-low rates, they boldly declared that they “will do what it takes,” which was fine with the politicians since it involved printing more money. But anyone who believes the central bank is equally free to do what it takes to rein in inflation using high rates is naïve. The politicians will fear a recession, budget-busting interest costs, and most of all: the opposition getting elected.
On the other hand. the prospect of Inflation being allowed or even welcomed at 3% or 4% isn’t a mere abstraction to the people, companies, and foreign governments who will have to pay for it. Even if all went according to plan with a controlled year or two of overshoot followed by a return to 2%, it would still be very costly to the elephant. And, expecting an orderly return to 2% requires a huge leap of faith.
Perhaps some of the targeting ideas might be workable if the Fed and other central banks were able to control things as well as the targeters assume. But the reality is that as things get tense, the central bank’s spot in the pecking order can quickly fall to third behind the elephant and the politicians. When inflation picks up, these last two tend to reinforce it.
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