Two Percent Inflation: A Good Thing or A Bad Thing

Apr 8 2014, 4:08pm CDT | by

Maybe it’s just me, but it seems like every time Janet Yellen speaks publicly she goes out of her way to call attention to the FOMC’s two percent inflation target and remind us that she takes that target very seriously. She sincerely wants higher inflation for the good of the economy and she may be right to do so, but it makes me cringe.

When Ben Bernanke joined the Board of Governors the first time, he had a goal to implement an inflation target. Fortunately, from my point of view, Alan Greenspan never let that idea come to a vote. While I could sort of understand the academic case for positive inflation, in my gut I didn’t want to vote for inflation. Among other reasons, I didn’t want to have to explain such a vote to the folks back home. Fortunately, I was gone by the time it finally came to a vote during Mr. Bernanke’s later stint as Chairman.

I was reminded of that today as I looked over some promotional material on my broker’s web site, particularly a chart on how inflation destroys purchasing power. A graph showed what happens to the value of $50,000 after 25 years at a four percent inflation rate, a three percent inflation rate, and a two percent inflation rate. Hey, that two percent inflation rate was what the FOMC settled on as desirable. A two percent inflation rate—the Fed’s target—reduces the purchasing power of $50,000 to $30,477 in 25 years. That doesn’t look so benign to me.

One argument for a positive inflation rate is easy to understand, but I’m not sure it requires a rate as high as two percent. That is the argument that inflation might get so low that we accidentally slip into deflation. The Japanese experience has taught us that we don’t want to go there. But, wouldn’t one percent be a sufficient buffer?

Another argument that makes sense to central banker types is the “zero bound” argument. If you have three percent inflation, the central bank can push the policy rate down to one percent, which translates to a negative two percent in real terms. A zero nominal rate would be a powerful negative three percent with three percent inflation. But if inflation is zero, the real rate can be no lower than the nominal rate, hence the “zero bound.” We hear chatter that the ECB may be contemplating a negative nominal rate to deal with this problem.

Back in school I do vaguely recall discussions of inflation that went slightly beyond the superficial. I remember the point being made that the evils of inflation are really evils of unanticipated inflation—a surprise level of inflation. If the inflation rate is steady and anticipated, then other prices and incomes would adjust to it and remove most of the damage. The purchasing power of a dollar, or $50,000, would still be eroded by inflation but wages, incomes, and interest rates would also be higher as an offset.

Money illusion is involved if we prefer six percent wage increases during a period of three percent inflation to three percent wage increases with zero inflation, but money illusion may have its uses. For example, a high unemployment rate would be easier to remedy if wages could fall. It is easier for wages to fall in real terms if they don’t have to fall in nominal terms. Adjusting to changing competitive conditions internationally is likely to be easier if there is sufficient inflation to have flexible real wages despite inflexible nominal wages.

I’m sure that Ms. Yellen and Mr. Bernanke can explain the benefits of 2 percent inflation better than I can. I’m only glad I don’t have to. Besides, why couldn’t they have chosen one percent as a target?


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