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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.
Published in General
Japan’s near-current and past attempts at breaking out of their deflation/stagnation haven’t worked; although the most recent moves may be having an effect.
Abenomics–Keynesian fiscal stimulus and easy money, coupled with moves to push growth on the heels of the rising prices the first two moves generated–has produced inflation. But.
Inflation this year is running too high, and contradictorily, lately their stock market (a harbinger of future economic performance, but with little predictive value in terms of timing and with a need for sustained market rise or fall to indicate an economy’s future) has been falling.
Eric Hines
I’m with Ed G. mild deflation is not the big bugaboo that everyone is making out. Japan’s deflationary problems are a sign of their demographic and economic sclerosis not the other way around.
These examples are indeed pre-WWI….In fact most of the 1870s to about 1915.
Thanks Eric
You are partially correct but are not articulating the mechanisms clearly. Lowering interest rates reduces the cost of capital and is intended to stimulate production and investment. The manner in which it stimulates consumption is through inflation (as you have noted elsewhere).
Well. The whole point of having constant inflation is to make the economy freer, in the presence of a political system that (we all think) cannot tolerate nominal wage cuts.
The whole point of having constant inflation is to make the economy freer….
Let me suggest a slight rephrasing: The whole point of constantly having inflation….
Eric Hines
This is not deflation that has hit the computer industry, it is normal functioning of the economy and “creative destruction”. Just like the replacement of the horse and buggy and flat screen TVs that run forever at low power replacing 1960’s round tube CRT, hand-wired color TVs that would cost $4,000 each today.