Anyone who has tried their hand at archery knows there's an easy solution for arrows that fall repeatedly short of the target―aim higher.
That's just the situation in which Federal Reserve officials find themselves. And some appear, albeit too gradually, to be learning their lesson.
The Fed, which has fallen short of its 2% inflation target for most of the recovery from the Great Recession, is undertaking a review of its monetary policy "strategy, tools and communications" led by Vice Chair Richard Clarida.
Officials recognize that, with interest rates at just 2% and unlikely to go much higher if at all given weakening economic conditions, they will have limited room to cut borrowing costs when the next recession hits before hitting zero again. That will force policymakers to again purchase bonds in large quantities, a policy that proved effective but controversial during the last downturn.
If the Fed had a higher inflation target going into the 2007-2009 slump, policymakers would have been forced to respond earlier and more aggressively to the downturn, likely shortening its severity and duration.
Moreover, policymakers would have refrained from raising rates over the last two years despite signs that, despite a low unemployment rate, wages for most workers had yet to pick up substantially, certainly not enough to make up the ground lost during the recession.
Low inflation sounds like a good thing, and it generally is. But inflation that is chronically stagnant, or worse, a persistent cycle of falling prices and wages known as deflation (with which the economy flirted during the financial crisis), is the surest sign of an economy that is performing below its full potential.
Importantly, the flipside of a disinflationary economy is a chronically weak labor market where workers lack the bargaining power to ask for raises, and thus inequality rises.
Also, central banks know what to do if inflation gets out of hand―they can raise interest rates. Cutting them when the economy is spiraling out of control and no one wants to borrow is sometimes likened to "pushing on a string" for its lack of potency.
By running the economy hotter than it has in recent decades, the central bank could allow for more jobs to be created without major downsides. Importantly, those who benefit most from such a policy would be those at the bottom of the income ladder, many of whom are largely excluded benefits of growth even in decent times.
"Central banks are generally believed to have effective tools for preventing persistent inflation overshoots, but the effective lower bound on interest rates makes persistent undershoots more likely," Clarida said in a February speech describing the framework review.
"Persistent inflation shortfalls carry the risk that longer-term inflation expectations become poorly anchored or become anchored below the stated inflation goal."
Clarida says the review "will be wide ranging, and we will not prejudge where it will take us," suggesting the ultimate result is very much a work in progress.
As someone who grew up under a hyperinflationary Brazilian economy during the 1980s, I offer my two cents: We're not in Rio anymore―It's time for the Fed to adopt a higher inflation target.
What's the right number exactly? Two percent was chosen rather randomly, a trend that began in New Zealand and was then adopted by other mimicking, consensus-seeking central bankers.
Let's start with 4%, as ex-IMF economist Olivier Blanchard has suggested, and see what happens.
