Why 2 Percent Inflation? Why Not Zero? — King Banaian

 

As Jim notes, inflation figures have come out and, depending on which data you use, you might say inflation was 1.5%, 1.7% or something in between. We are told that this is below the Fed’s target of 2%.

Question: Why is a central bank that is told to maintain price stability choosing 2% as its goal? Why wouldn’t price stability mean stable prices, or zero inflation?

In Europe, the central bank uses a devices called the Harmonized Index of Consumer Prices, and aims for its rate of growth (or inflation rate) to be “below, but close to, 2% over the medium term.” In explaining its position, the European Central Bank cites three reasons for 2 over zero:

1. The risk of deflation. Monetary policy relies on interest rates to stimulate demand, but in a deflationary environment interest rates tend to move towards zero, making monetary policy ineffective. This is an odd concern for the ECB, as it has no responsibility for output growth, only for price stability. In the US case, there is more a need for protection from the zero bound: It is what lead to quantitative easing. Without QE, the Fed would have invited further expansion from fiscal policy, and perhaps more fundamental changes in the Fed’s charter — something we might want to avoid, given what we saw Congress do with Dodd-Frank.

2. No matter which measurement of inflation is used (HICP in Europe, core PCE deflator in the US), there is the risk that your measurement has errors. If you believe the cost of low inflation is less than the cost of low deflation, you might want to lean on the scale a bit to move the target inflation rate above zero.

3. Inflation isn’t the same in every part of a country or zone of countries. CPI in my part of the country — the Minneapolis-St. Paul area — was 1.9% in 2013. In Phoenix it was 1.3% for 2013, and 0.2% for the last six months. Yet we all have to work with one Federal Reserve. In Europe, the inflation rate in Greece differs from that in France, but they decided to stick themselves with one ECB. So you might want a few areas with a little more than 2%, others with a little less, but nobody (hopefully) with less than zero.

Notice that in each point above  I included the words “might want.” There is disagreement among policy professionals about how much you “might want” — a debate that continues, sometimes even here at Ricochet. And it’s reasonable for people to disagree. You might argue that a small amount of deflation isn’t costly; others will disagree. Most economists believe that some rate slightly above zero is desired.

In my own view, the ECB’s phrasing of “below, but close to” is better than thinking you haven’t done enough if you get to 1.7% or 1.8%, because of the measurement issues, which I think are substantial. But it’s worth listening carefully to hear why an economist thinks inflation needs to be higher, or why it may already be too high.

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  1. Roberto Inactive
    Roberto
    @Roberto

    King Banaian:

    1. The risk of deflation.

    The true bugbear indeed, notice how deflation has absolutely decimated the computer industry. Each and every year more powerful integrated circuits, more memory etc. all for lower prices which no one ever purchases. Look at the shattered wrecks of industry that remain: Intel, IBM, AMD etc. veritable zombies which are barely hanging on.

    It is a lucky thing other portions of the US Economy are spared this grim fate.

    • #1
  2. PHCheese Inactive
    PHCheese
    @PHCheese

    anonymous:

    At a rate of inflation of 2%, money loses a third of its purchasing power in 20 years. With interest rates on investments generally considered as safe (bank deposits, money market funds, treasury securities) below this level (especially after tax), saving is a sucker’s bet.

    This only leaves speculation for those hoping to accumulate capital for retirement and to pass on to their children. It’s no wonder financial assets are in bubble territory.

    And this presumes one can trust government metrics of inflation, as we have been discussing on the member feed.

     John ,I think you are on track. Another aspect is that our 17 trillion debt will seem like 5.6 trillion. Thrown in the fact they either lie or over shoot the mark that 5.6 could be more like 4 trillon in 2034 dollars. You can only get away with this with a reserve currency.

    • #2
  3. King Banaian Member
    King Banaian
    @KingBanaian

    John,as I noted the rate of inflation could be mismeasured.  (See my reason #2.)  One thing I watch are the measures from the Cleveland Fed, which might lead you to look closer to median CPI at 2.1%.  

    As to deflation, the biggest issue there is the likelihood that  deflation leads to waiting for the lower prices.  In the case of computer technology, the novelty and wonderfulness of the stuff makes us unwilling to wait, so demand is supported in the face of falling prices.  Not so for milk or bread … or labor.  Deflationary spirals can be costly; their impact on debt, and debtors’ ability to repay, are substantial and not to be taken lightly.

    • #3
  4. civil westman Inactive
    civil westman
    @user_646399

    Why 2% rather than zero?
    1. It is a hidden tax on savers. Politicians escape blame.
    2. Debt is repaid in cheaper dollars. The bigger the debt, the greater the benefit. We all know the biggest debtor.
    3. The Fed (aiding and abetting congress) arrogantly believes it has a vernier to control it. i.e. because it thinks it can. Another boon, perpetrated under the rationale of “common good.”

    Regardless of the reason, it is legalized theft; a sophisticated form of counterfeiting devaluing the capital of a cowed, compliant herd.

    • #4
  5. Eric Hines Inactive
    Eric Hines
    @EricHines

    Price stability is more about predictable prices, than it is about flat prices.  2% inflation provides some engineering slop/cushion to avoid deflation, which is a more serious problem for the economy as a whole, if not necessarily for selected sectors of it. 

    With moderate inflation, borrowers repay with devalued dollars–good for the borrower, not so good for the lender.  With moderate deflation, it’s the opposite.  But the lender can afford the relatively small loss better than the borrower–who isn’t just Intel, IBM, et al, but us individuals, so there’ll be less lending in a mild deflationary environment than there would be borrowing in a mild inflationary environment.

    With moderate inflation, prices rise over time, so there’s an incentive (however mild) to buy now rather than later–good for an economy consisting primarily of consumption.  With moderate deflation, the incentive is to put off consumption–bad for an economy consisting primarily of consumption.

    The deflationary environment’s combination of lowered, and lowering, consumption with lowered, and lowering, lending hurts an economy much more than the opposite in a moderately inflating economy.

    Eric Hines

    • #5
  6. Ed G. Member
    Ed G.
    @EdG

    Eric Hines:

    …..

    With moderate inflation, borrowers repay with devalued dollars–good for the borrower, not so good for the lender. With moderate deflation, it’s the opposite. But the lender can afford the relatively small loss better than the borrower–who isn’t just Intel, IBM, et al, but us individuals, so there’ll be less lending in a mild deflationary environment than there would be borrowing in a mild inflationary environment.

    …..

    After what we experienced in the last decade or two, isn’t a little of that a good thing? Don’t lenders need to get pickier and borrowers need to bear a little more cost for credit? Wasn’t too-easy credit one of the big drivers of the dotcom bubble, the housing bubble, and now the education bubble?

    • #6
  7. Ed G. Member
    Ed G.
    @EdG

    Eric Hines:…..

    With moderate inflation, prices rise over time, so there’s an incentive (however mild) to buy now rather than later–good for an economy consisting primarily of consumption. With moderate deflation, the incentive is to put off consumption–bad for an economy consisting primarily of consumption.

    …..

    I don’t see why this is something that should be supported or encouraged.  We conservatives complain all the time that the US (public and private) borrows too much, spends too much, consumes too much, doesn’t produce enough, doesn’t save enough. And as a result we have the welfare state, bankruptcy on the horizon, and loss of status and influence in the world also on the horizon.

    • #7
  8. Ed G. Member
    Ed G.
    @EdG

    King Banaian:

    John,as I noted the rate of inflation could be mismeasured. (See my reason #2.) One thing I watch are the measures from the Cleveland Fed, which might lead you to look closer to median CPI at 2.1%.

    As to deflation, the biggest issue there is the likelihood that deflation leads to waiting for the lower prices. In the case of computer technology, the novelty and wonderfulness of the stuff makes us unwilling to wait, so demand is supported in the face of falling prices. Not so for milk or bread … or labor. Deflationary spirals can be costly; their impact on debt, and debtors’ ability to repay, are substantial and not to be taken lightly.

     I think inflationary spirals, even the gradual one we experienced over the last however many decades, are not to be taken lightly either. The transformation from a producing/saving country to a consuming/borrowing country has been devastating for us.

    • #8
  9. Eric Hines Inactive
    Eric Hines
    @EricHines

    After what we experienced in the last decade or two, isn’t a little of that a good thing? Don’t lenders need to get pickier and borrowers need to bear a little more cost….

    Sure.  But we don’t need deflation to achieve that.  We need government out of the way, with fewer regulations and more free market benefits and consequences.  That’s on us citizens to enforce through repeated consequential elections.

    If we don’t do our job, interfering government will get in the way regardless of the economic environment.

    Eric Hines

    • #9
  10. Eric Hines Inactive
    Eric Hines
    @EricHines

    We conservatives complain all the time that the US (public and private) borrows too much, spends too much, consumes too much, doesn’t produce enough, doesn’t save enough.

    You, maybe.  This Conservative says that about government, not about private citizens making their own choices.  After all, it’s individual self interest–greed–is the invisible hand that produces prosperity for all.

    Eric Hines

    • #10
  11. Ed G. Member
    Ed G.
    @EdG

    Eric Hines:

    After what we experienced in the last decade or two, isn’t a little of that a good thing? Don’t lenders need to get pickier and borrowers need to bear a little more cost….

    Sure. But we don’t need deflation to achieve that. We need government out of the way, with fewer regulations and more free market benefits and consequences. That’s on us citizens to enforce through repeated consequential elections.

    If we don’t do our job, interfering government will get in the way regardless of the economic environment.

    Eric Hines

     And if fewer regulations, more-free market, and real consequences were to combine and result in deflation then would you support the fed’s effort to adjust that to the target of 2% inflation? I agree with less distortion, but that also includes efforts to correct away deflation that might naturally occur.

    • #11
  12. Eric Hines Inactive
    Eric Hines
    @EricHines

    The transformation from a producing/saving country to a consuming/borrowing country has been devastating for us.

    This is only partly related to inflation.  Another aspect has been the government’s punishment for saving with its manipulation of interest rates, including their artificial suppression these last several years.  Which, in addition to suppressing such saving as we might have done otherwise, has actively punished “widows and orphans” who are, still, dependent on fixed income devices for their living.

    Eric Hines

    • #12
  13. Ed G. Member
    Ed G.
    @EdG

    Eric Hines:

    We conservatives complain all the time that the US (public and private) borrows too much, spends too much, consumes too much, doesn’t produce enough, doesn’t save enough.

    You, maybe. This Conservative says that about government, not about private citizens making their own choices. After all, it’s individual self interest–greed–is the invisible hand that produces prosperity for all.

    Eric Hines

     I included the private bit only to highlight the depth of the problem caused by the corrections and distortions.

    • #13
  14. Ed G. Member
    Ed G.
    @EdG

    Otherwise, I don’t think that greed and self-interest are the same, and I also don’t think it’s sufficient to produce prosperity for all. The world is filled with greed and self-interest, yet it’s hardly accurate to say that it’s filled with prosperity; this is partly because people are wrong about their self-interest astoundingly often and partly because of distortions to rational incentives. That doesn’t mean I favor some referee judiciously regulating who gets enough freedom to excercise their perceived self-interest, but if we have to have a target (do we?) then I don’t see why it should err on the side of inflation.

    • #14
  15. Eric Hines Inactive
    Eric Hines
    @EricHines

    Ed G.: And if fewer regulations, more-free market, and real consequences were to combine and result in deflation then would you support the fed’s effort to adjust that to the target of 2% inflation? I agree with less distortion, but that also includes efforts to correct away deflation that might naturally occur.

    Sure. Just as I support Fed efforts to keep inflation within a band–that price stability bit. But what I support is the Fed’s efforts to keep inflation within a band using, among other things, interest rates as a tool, not the Fed’s efforts to manipulate interest rates as an end in itself.

    Also, deflation is unlikely to occur naturally. One of the outcomes of (invisible hand-driven) increasing prosperity is a material aspect of that: more money. Money is created from that prosperity faster than goods and services, and that’s the stuff of inflation, not deflation.

    Of course, with our aging population, we might be entering a different regime, with money not necessarily growing faster than goods and services. That puts premiums on encouraging immigration and on immigration reform, but that’s for another thread.

    Eric Hines

    • #15
  16. Ed G. Member
    Ed G.
    @EdG

    Eric Hines:

    The transformation from a producing/saving country to a consuming/borrowing country has been devastating for us.

    This is only partly related to inflation. Another aspect has been the government’s punishment for saving with its manipulation of interest rates, including their artificial suppression these last several years. Which, in addition to suppressing such saving as we might have done otherwise, has actively punished “widows and orphans” who are, still, dependent on fixed income devices for their living.

    Eric Hines

     Right, but aren’t generally lower interest rates a tool/distortion meant to avoid deflation? Otherwise why was the interest rate lowered so much? Doesn’t this corroborate my point about over extension on the debt side as a result, at least partially, of policy being explicitly inflationary?

    • #16
  17. Ed G. Member
    Ed G.
    @EdG

    Eric Hines:

    Ed G.: And if fewer regulations, more-free market, and real consequences were to combine and result in deflation then would you support the fed’s effort to adjust that to the target of 2% inflation? I agree with less distortion, but that also includes efforts to correct away deflation that might naturally occur.

    Sure. Just as I support Fed efforts to keep inflation within a band–that price stability bit. But what I support is the Fed’s efforts to keep inflation within a band …..

    …..

     Why not increase the acceptable band to include some mild deflation if that occurs?

    • #17
  18. Ed G. Member
    Ed G.
    @EdG

    Eric Hines:…..

    Also, deflation is unlikely to occur naturally. One of the outcomes of (invisible hand-driven) increasing prosperity is a material aspect of that: more money. Money is created from that prosperity faster than goods and services, and that’s the stuff of inflation, not deflation.

    …..

     I suppose this is an area of disagreement: I don’t believe it’s rational to expect that prosperity will always be the result of the invisible hand. Sometimes people make terrible decisions that are difficult to recover from. Sometimes those bad decisions are made en masse. Sometimes disaster strikes. Sometimes competitors get the better of you.

    • #18
  19. Eric Hines Inactive
    Eric Hines
    @EricHines

    The world is filled with greed and self-interest [thoroughly edited to fit the word count]

    Whose definition of what a man’s self interest is applies?  The interference with prosperity growth is those distortions, including those imposed for that other man’s better interests  because someone other than that man Knows Better, those government interventions away from a (pretty much) unfettered free market.

    No, we don’t need an inflation band target for a free market to operate, but it helps.  Without the target, price movements swing much more widely, but the ones who are hurt the most by those are the least among us, with the fewest resources to get through bad times.

    Greed–self interest: You have something I want.  I want it, for my own selfish reasons.  I have something you want, for your own selfish reasons.  We agree on an exchange, and afterward we’re both richer than we were before: we each have something of value to us that we didn’t have before the exchange.  And neither of us paid more than the thing was worth to us; we might even have paid less.  Greed in action.

    Eric Hines

    • #19
  20. Eric Hines Inactive
    Eric Hines
    @EricHines

    Part I: [Aside: 2.0 has improved–these comments are going up faster than I can respond.  Didn’t happen with 1.0.]

    …aren’t generally lower interest rates a tool/distortion meant to avoid deflation? Otherwise why was the interest rate lowered so much? Doesn’t this corroborate my point about over extension on the debt side….

    No, low interest rates are a tool for stimulating consumption.  A side effect of that stimulus is inflation, which spikes interest rates.  Higher interest rates are for killing that inflation.  The trick is to stay ahead of the cycle: with the stimulus in effect, raise the rates above the inflation rate–but not too much above–to short circuit the inflation so rates can be lowered to an intermediate, historically effective level.  It’s also a matter of more is not better, nor is longer of necessity better than shorter.  Leaving the rates outside a normal band for too long builds up too much of what’s being held back until the dam collapses. 

    Eric Hines

    • #20
  21. Eric Hines Inactive
    Eric Hines
    @EricHines

    Part II: These low rates are piling up cash because the lenders can’t make any money lending.  When the money flows, it’ll move rapidly, with high inflation resulting.  This is exacerbated by the Fed’s QEx program of buying debt instruments in an attempt to encourage lending.  But all that’s happening is the lenders are lending to government, not lending into the economy.

    When that starts to get unwound, the Fed can hold the instruments until maturity (they’re buying long-term debt, now), or it can sell the instruments.  All that money gets dumped into the economy.  More inflation.

    Eric Hines

    • #21
  22. Eric Hines Inactive
    Eric Hines
    @EricHines

    Why not increase the acceptable band to include some mild deflation if that occurs?

    Inflation tends to be self-correcting: Folks can’t afford that at the high prices, so they don’t buy.  Prices come down.

    Deflation tends to be open-ended.  Prices are falling, so folks wait to buy.  Falling demand leads to less production.  Less production leads to lower employment.  Lower employment leads to less buying, even at the lowering prices–functionally, more waiting to buy.  Falling demand….

    In the end, all that gets bought are the bare necessities, and usually of poor quality.  That’s a subsistence economy.

    Eric Hines

    • #22
  23. Eric Hines Inactive
    Eric Hines
    @EricHines

    Part I: I don’t believe it’s rational to expect that prosperity will always be the result of the invisible hand. Sometimes people make terrible decisions that are difficult to recover from. Sometimes those bad decisions are made en masse. Sometimes disaster strikes. Sometimes competitors get the better of you.

    Nobody rational is saying that prosperity will always be the result of the invisible hand, including Smith.  Only that the invisible hand improves the odds over the house more so than any other system.

    Cycles occur, and deviations from an optimal level are frequent and often large.  Life isn’t monotonically improving.  Individuals will make terrible decisions, and disasters will occur, regardless of the nature of an economy.   There always will be winners and losers. 

    Eric Hines

    • #23
  24. Eric Hines Inactive
    Eric Hines
    @EricHines

    Part II:

    But in a free market, under the invisible hand, it trends better over the long run.  Prosperity grows to better handle disaster: who did better with an earthquake, San Francisco or Haiti?  Prosperity grows to better handle cyclical failure.  Whose economy handled the Panic of 2008 better–ours or Russia’s?  In a free market, today’s loser has a chance of being tomorrow’s winner in any competition.  In a centrally planned economy–say the PRC’s or USSR’s or (occupied) eastern Germany’s, how often did winners and losers swap places?

    Eric Hines

    • #24
  25. Big Green Inactive
    Big Green
    @BigGreen

    The purpose of low interest rates is not necessarily to stimulate consumption.  Low interest rates are intended to reduce the cost of capital, not to induce consumption.

    • #25
  26. Big Green Inactive
    Big Green
    @BigGreen

    Eric Hines:

    Why not increase the acceptable band to include some mild deflation if that occurs?

    Inflation tends to be self-correcting: Folks can’t afford that at the high prices, so they don’t buy. Prices come down.

    Deflation tends to be open-ended. Prices are falling, so folks wait to buy. Falling demand leads to less production. Less production leads to lower employment. Lower employment leads to less buying, even at the lowering prices–functionally, more waiting to buy. Falling demand….

    In the end, all that gets bought are the bare necessities, and usually of poor quality. That’s a subsistence economy.

    Eric Hines

     This most certainly didn’t happen from 1870 to the 1915 or so.  Plenty of deflation and plenty of consumption.  Depends on what type of deflation you are talking about.  Falling real prices of goods is a good thing.

    • #26
  27. user_48342 Member
    user_48342
    @JosephEagar

    Big Green:

    Eric Hines:

    Why not increase the acceptable band to include some mild deflation if that occurs?

    Inflation tends to be self-correcting: Folks can’t afford that at the high prices, so they don’t buy. Prices come down.

    Deflation tends to be open-ended. Prices are falling, so folks wait to buy. Falling demand leads to less production. Less production leads to lower employment. Lower employment leads to less buying, even at the lowering prices–functionally, more waiting to buy. Falling demand….

    In the end, all that gets bought are the bare necessities, and usually of poor quality. That’s a subsistence economy.

    Eric Hines

    This most certainly didn’t happen from 1870 to the 1915 or so. Plenty of deflation and plenty of consumption. Depends on what type of deflation you are talking about. Falling real prices of goods is a good thing.

    Is that relevant to today, though?  Could such a situation happen again, politically?  The conventional wisdom is that modern democracies cannot deal with the nominal wage cuts necessitated by deflation.

    • #27
  28. user_48342 Member
    user_48342
    @JosephEagar

    Eric Hines:

    The transformation from a producing/saving country to a consuming/borrowing country has been devastating for us.

    This is only partly related to inflation. Another aspect has been the government’s punishment for saving with its manipulation of interest rates, including their artificial suppression these last several years. Which, in addition to suppressing such saving as we might have done otherwise, has actively punished “widows and orphans” who are, still, dependent on fixed income devices for their living.

    Eric Hines

     You speak as if higher investment returns exist, but are being denied savers by the Fed.  That simply isn’t the case.  Right now, there are more savings in the world than there are investment opportunities.  That situation will end, probably in the next few years, but for now the Fed really is following the market with its interest rate policies.

    (Note that this situation is complicated by the fact that at the national level, America has too little savings; it is the rest of the world that has too much.  It’s a diffcult situation).

    • #28
  29. Ed G. Member
    Ed G.
    @EdG

    Joseph Eagar:

    Big Green:

    …..

    This most certainly didn’t happen from 1870 to the 1915 or so. Plenty of deflation and plenty of consumption. Depends on what type of deflation you are talking about. Falling real prices of goods is a good thing.

    Is that relevant to today, though? Could such a situation happen again, politically? The conventional wisdom is that modern democracies cannot deal with the nominal wage cuts necessitated by deflation.

     I don’t think the answer is to deny that deflation is sometimes real and attempt to correct it away. I’m gonna wash that man right outta my hair becomes I’m gonna inflate that savings right outta the air!

    • #29
  30. Ed G. Member
    Ed G.
    @EdG

    Besides, isn’t it possible that lower prices would be offset by higher demand? It’s not as if we dip below zero on Tuesday and then we’re all faced with paycuts on Wedensday. It’s not as if desire to consume ceases. It’s not as if the promise that the Iphone will be 2% cheaper next year will stop people from lining up outside the store to get the very latest model as soon as it’s available. Believe it or not, inflation/deflation rates don’t generally play a direct role in discrete purchasing decisions – we need what we need and we want what we want. Also, if consumers are spending less on necessities then that creates more room for luxuries’ prices  to be less responsive to the deflationary environment.

    • #30
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