Home / Economy / Must inflation be brought down all the way to 2%?


“Why must inflation be around 2%?" is a question that obsessed central bankers back when inflation was stubbornly below their favorite target. It makes more sense to ask it now.

This past week, a string of data has suggested that inflation is finally on a downward trend. The U.S. personal-consumption expenditures price index excluding food and energy—the Federal Reserve’s preferred measure of inflation—recorded its second-smallest monthly increase for the year, even as consumer spending jumped and job growth continued. Meanwhile, eurozone inflation receded to 10% in November, suggesting that October’s 10.6% was the peak.

Stocks have rallied, especially after Fed Chairman Jerome Powell said Wednesday that interest rates will go up in smaller increments from now on. But he also indicated that the tightening is far from over. Indeed, central bankers don’t ultimately care if inflation stops rising: They want it to go down, back to the 2% number they are mandated to hit.

It underscores the misalignment between their interests and everybody else’s, which should worry investors.

Inflation in many rich countries has been decelerating since July, yet economists don’t expect it to return to 2% until a distant 2025, based on median forecasts. Derivatives markets price in that the Fed, the European Central Bank and the Bank of England will stop raising rates in 2023, cut them later in the year, and then sit on their laurels for two full years as inflation grinds down.

But what if inflation stabilizes at a higher rate—say between 4% and 6%? In this plausible case, central banks may be compelled to start needlessly raising rates again, catching investors off guard. It would make a lot more sense to raise the inflation target instead, or define it as a wider range.

Yes, out-of-control inflation involves large disruption, as uncertainty about costs gives businesses a reason to cut production, and workers with diminishing purchasing power resort to strikes. But such problems stem from inflation accelerating, not its being high.

Inflation of 4% is perfectly compatible with a healthy economy that isn’t overheating. A possible reason would be the fragmentation of global supply chains, which research suggests previously suppressed price pressures.

Some on Wall Street fear pay wouldn’t keep up and hit consumption, as the commodity shock is doing now. But, in the long term, economies tend to grow, which means “real" incomes do too. And historical data shows no evidence that higher inflation diverts less of this income to wages relative to profits, or vice versa.

To be sure, problems arise when inflation is very high or, by contrast, when there is deflation. This is why most economists advocate a small but positive rate of price growth.

There is no reason it must be 2%, however. The Reserve Bank of New Zealand, which pioneered inflation targeting in 1989, arbitrarily chose a 0%-to-2% range simply because then-Minister of Finance Roger Douglas thought it sounded low. It probably helped that the historical median CPI growth in countries such as the U.S. and the U.K. was roughly 2%.

There could be trouble if raising the inflation target in itself triggered wage pressures that fed back into prices. Back when inflation stayed below 2%, economists such as Olivier Blanchard, Larry Summers and Jordi Galí insisted it was a problem in need of solving, and that a higher target could do it. This outcome is unlikely, though: Expectations of inflation are less important in price setting than whatever inflation has just done.

For the sake of workers, firms and investors, the time to rethink targets is neither when inflation is low nor when it is accelerating, but when it is high and stable.

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