The Dart Lands on 2%

How did that 2% inflation rate get sanctified? Neil Irwin of the New York Times once traced the origins of the totem back to Dan Brash, a former kiwi farmer who became governor of the Reserve Bank of New Zealand in 1988. Shortly after Brash took office, the NZ parliament mandated that the central bank pick an inflation target and granted it the political independence to meet it. Working with the nation’s finance minister David Caygill (successor to the legendary Roger Douglas, whose policy of aggressive market liberalization had worldwide influence), Brash settled on 2%. The idea spread to central bankers around the world.

Should there be such a target? The consensus of those who matter for such things seems to be yes, but one important dissenter was the current chair of the Fed, Janet Yellen. At FOMC meetings in 1995 and 1996, Yellen argued strongly against adopting a formal inflation target. In January 1995, she denounced a single-minded focus on inflation at the expense of real outcomes like employment and income growth. Underscoring the point, the said that “a wise and humane policy is occasionally to let inflation rise even when inflation is running above target.” Further, the costs of inflation targeting could be high: “Each percentage point reduction in inflation costs on the order of 4.4 percent of gross domestic product…and entails about 2.2 percentage-point-years of unemployment in excess of the natural rate.” For her, there was no proof that keeping inflation low improved economic performance, making those costs not worth paying.

She developed the point a year-and-a-half later, at the July 1996 meeting of the FOMC. She reiterated that very low inflation has no demonstrable economic benefit, other than perhaps reducing tax distortions, and those problems could be addressed legislatively without incurring the economic costs of disinflation. She also touted the flexibility afforded by slightly higher inflation: it made it easier for real interest rates to go negative when the economy needs stimulus, and it also disguised real wage cuts that might be necessary in response to demand shocks or to balance labor supply and demand across sectors. Of course, inflation in 1995 and 1996 was around 3%; she thought lowering that to 2% wouldn’t hurt much, but anything beyond that would be uselessly painful. But now even 2% might seem constraining with the ZLB having become a fact of life, and one that might endure.