In June 2022, America’s post-COVID inflation surge reached its peak at over 9 percent. Politicians were clamoring for a fix; President Biden’s approval ratings suffered; and the Federal Reserve steadfastly continued raising interest rates, signaling its determination to aggressively pursue price stability even if it risked a spike in unemployment. But just over a year later, in July, consumer prices rose by a much more manageable 3.2 percent.
That’s a pretty dramatic turnaround, and there’s good reason to consider this a success story. After all, inflation had been at a 40-year high, and instead of the economy entering a wage-price spiral as some experts warned, the consumer price index steadily declined — and without a recession to boot. In fact, wages are now keeping up with and even outpacing inflation, meaning workers are less likely to feel the pinch. So why do so many people still think inflation is a major problem for the United States?
Part of the answer probably lies in how the Fed has reacted to this turn of events. After announcing the central bank’s decision to pause interest rate hikes in June, Fed chair Jerome Powell gave a muted assessment. “Inflation has moderated somewhat since the middle of last year,” Powell said at a press conference. “Nonetheless, inflation pressures continue to run high, and the process of getting inflation back down to 2 percent has a long way to go.” He added that additional interest rate hikes would be appropriate in the months ahead, and in July, the Fed indeed resumed raising interest rates — this time to a 22-year high.
There’s only one problem with Powell insisting that there’s still a long way to go: It’s that his destination — the 2 percent inflation target — is not some unimpeachable marker of price stability but an arbitrary one inspired by, believe it or not, an off-the-cuff comment New Zealand’s finance minister made in a television interview in 1988.
After being pressed on whether the country’s trouble with inflation had been brought under control, the finance minister said that he wouldn’t be satisfied until the country’s inflation rate was brought down to somewhere between 0 and 1 percent. That prompted New Zealand’s central bank to figure out what a reasonable target would actually be, and after some research — which one of the central bankers from that time would later admit “wasn’t ruthlessly scientific” — economists landed on the ideal inflation target to, at maximum, be 2 percent. New Zealand became the first country to mandate a numeric inflation target, and other central banks soon followed.
By 1996, a 2 percent inflation target had become an unwritten rule at the Fed, and in 2012, then-Fed chair Ben Bernanke made it official. Of course, price stability has always been part of the Fed’s mandate, but before any of this happened, the Fed had never been fixated on such a specific number. After inflation had been brought down from double digits to 4 percent in the 1980s, for example, the Fed more or less considered its mission accomplished.
This isn’t to say that 2 percent is an entirely made up number. To the contrary, there is a bit of sense behind it. First, some inflation is necessary to provide a buffer against deflation. Second, interest rates in an economy with positive inflation are generally higher than one without any inflation, so a central bank — whose primary tool is controlling interest rates — has more leverage to stimulate the economy when a recession hits. The trick is to settle on an inflation target that’s high enough to prevent deflation but low enough so that consumers don’t actually feel it. And for the most part, maintaining inflation at around 2 percent has struck a decent balance over the last several decades.
But that doesn’t mean it’s the definitive benchmark. In fact, Bernanke, who made explicit the Fed’s 2 percent target, said as much himself. “I will say that I don’t see anything magical about targeting 2 percent inflation,” he said in 2015.
Since then, some economists have been arguing for a higher inflation target. Indeed, given the way inflation has eased, and given that wages have finally caught up, the Fed shouldn’t be in such a rush to get back to that 2 percent goal, lest it cause unnecessary harm to the economy. That’s why the Fed should hit the brakes on interest rates — at least for now.
That doesn’t appear to be what central bankers are thinking, though. As recently as last Friday, Powell again insisted inflation was still “too high” and warned against complacency. But as the Fed carries on its crusade to bring inflation down to 2 percent, it begs the question: Is chasing an arbitrary number really worth risking people’s jobs?
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