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Business News/ Economy / Is it time for Fed to raise interest rate target to 3%? Experts weigh in
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Is it time for Fed to raise interest rate target to 3%? Experts weigh in

Some experts argue that the US Federal Reserve should consider raising its interest rate target to 3 per cent to help combat inflation and provide cushioning against severe recessions. However, some experts argue that raising inflation targets would be futile.

The US Fed has been raising interest rates since March 2022. (AFP)Premium
The US Fed has been raising interest rates since March 2022. (AFP)

The US Fed has been raising interest rates since March 2022 in pursuit of bringing inflation down to its 2 per cent target level. It has been over a year since the Fed initiated one of the most aggressive battles against inflation in recent history. Inflation still poses a formidable challenge for the central bank to conquer.

While the Fed remains determined to lower inflation to 2 per cent, experts are increasingly suggesting that the US central bank should consider raising its interest rate target to 3 per cent.

Jason Furman, an economic policy professor at Harvard, in a column in Wall Street Journal, wrote that in the short run, the Fed should aim to stabilise inflation below 3 per cent and after achieving this goal, the central bank should shift to a higher target range for inflation.

"If the Fed were adopting an inflation target from scratch, it would likely choose a target above 2 per cent. A higher target inflation rate has costs, especially the time and attention people spend trying to account for how much their current dollars will be worth in a year or 10. But a higher target also has the benefit of helping cushion the economy against severe recessions," Furman wrote.

Furman further wrote when the economy slows down, if inflation is higher, businesses might choose to increase prices and freeze wages instead of resorting to widespread layoffs to save money. This can be more acceptable. Also, higher inflation can help the Fed encourage investment because when prices are expected to rise in the future, borrowing costs seem less burdensome for businesses.

"In 1996 the Fed decided that these costs and benefits were best balanced at a 2 per cent inflation rate after a discussion between Chairman Alan Greenspan and Governor Janet Yellen. At the time the interest rate on 10-year Treasurys was around 6 per cent and the federal funds rate had never been cut to zero. Today the 10-year Treasury yield is around 4 per cent, and we have spent nearly half of the past 20 years with interest rates at the zero lower bound," Furman wrote.

Furman's views found partial support from some of the prominent economists. Paul Krugman, the winner of the Nobel Memorial Prize in Economic Science, wrote on X (formerly Twitter) that he agreed with Jason Furman's call for a 3 per cent inflation target. However, he added that if the 3 per cent target is right, the war against inflation was already won.

"I agree with Jason Furman's call for a 3 per cent inflation target — the rationale for 2 per cent has been overtaken by a couple of decades' experience (and many of us have been saying this for a while). But I'm puzzled by his assertion that there's a lot of work still to do and that the hardest part may still lie ahead. Most measures of underlying inflation are currently sitting around. So if you think 3 per cent is the right target, shouldn't we be declaring victory? Or to put it a different way, if 2 per cent was a mistake, how many people should lose their jobs for a mistake?" Krugman wrote on X.

However, the debate has another side as well. Some experts believe that it would be futile for the Fed to raise inflation targets. The central bank's primary responsibility is to keep inflation under control while it also has the freedom to take a pause on rate hikes and tweak monetary policy if it feels growth is getting severely impacted.

G. Chokkalingam, Founder & Head of Research at Equinomics Research told Mint that raising the inflation target ultimately boils down to punishing the economy more severely in the short term or giving some lag in the long term.

"This argument doesn’t make sense from two perspectives. Though the inflation rate keeps a declining trend or remains constant, it remains in the positive zone most of the time. That would mean exponential growth in absolute price levels over the decades. It becomes imperative for the monetary authorities to give more focus on the given inflation rate targets as the public face huge absolute price rises even if authorities succeed in reducing inflation rates," said Chokkalingam.

"Secondly, in any case, monetary authorities have the flexibilities to pause in the short term if growth parameters indicate any major stress. Therefore it doesn’t make any sense to raise inflation targets," Chokkalingam said.

Read more: Higher interest rates could be the new normal despite inflation coming down; what should investors do?

Disclaimer: The views and recommendations above are those of individual analysts and broking companies, not of Mint. We advise investors to check with certified experts before taking any investment decisions.

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Published: 22 Aug 2023, 05:54 PM IST
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