Federal Reserve should increase target inflation rate to prepare for future recessions

By EPI

June 9, 2017

https://www.epi.org/press/federal-reserve-should-increase-target-inflation-rate-to-prepare-for-future-recessions/

In a new report, EPI Director of Research Josh Bivens argues that the Federal Reserve should increase its inflation target. Bivens argues that a higher inflation target will help to minimize the economic damage of and aid recovery from the next recession, as well as help eliminate household debt.

The Fed’s 2 percent annual inflation goal is too low, argues Bivens, because modern economies—including the U.S. economy—increasingly hit recessionary periods that persist even when short-term interest rates are lowered to zero. This zero lower bound (ZLB) on short-term interest rates limits the ability of conventional monetary policy to fight recessions and aid recovery. However, increasing the target inflation rate would allow inflation-adjusted interest rates to be lower at the ZLB than is possible under the current target.

The 2 percent inflation target has little rigorous grounding. Instead, it was set in the 1990s when the problem of chronic demand shortfalls leading to ZLB was largely overlooked, but the realities of modern economies have shown that this target is too low. Bivens identifies a number of influences that explain the growing problem of hitting the ZLB during recessions. Among these are rising inequality, a global savings glut, and aging populations. Because these influences show little sign of relenting in the near future, recessions where economies hit the ZLB will likely be increasingly common, and hence the primary conventional tool for fighting recessions—lowering short-term interest rates—will become less effective.

“There is compelling evidence that a higher target would help shorten future recessions and spur faster recoveries,” said Bivens. “The Fed should begin a process to re-evaluate the appropriateness of the current inflation target and to adjust upwards if they find that the evidence warrants it.”

Bivens points to the sharp rise in household debt in recent decades as another reason to move to a higher inflation target. With high levels of debt, unexpectedly low rates of inflation stemming from prolonged recessions can spark a vicious cycle. Falling inflation transfers purchasing power from borrowers to lenders, and because borrowers on average spend a higher share of this income, this puts a heavy drag on economic growth. Increasing the target inflation rate could help avoid these vicious cycles, amplified by high levels of debt.

Finally, Bivens notes that while most non-economists are deeply wary of faster inflation, expected increases in inflation very quickly translate into equivalent increases in wages and incomes, leaving living standards unchanged. A higher inflation target simply changes the range and effectiveness of tools available to fight future recessions.

Today’s EPI report accompanies a letter calling for a reassessment of the Fed’s inflation target signed by other prominent economists such as Nobel Prize winner Joseph Stiglitz, former Obama administration economic advisor Jason Furman, and economic historian Brad DeLong. This letter, spurred by the work of the Fed Up coalition, calls on the Federal Reserve to rethink its target inflation rate.