It was very surprising to hear Janet Yellen hint in public that there was a good case for raising the inflation target.
The economic logic of doing just that is very sound: if we think that equilibrium real interest rates are likely to be low for the foreseeable future, then the corollary is that the resting place for central bank rates is low. That means less room to cut rates in response to a future recession, leading to worse outcomes for the real economy [and inflation].
On the assumption that the Fed – or the combined might of the Fed and the Treasury – has the instruments to hit a higher target, raising the target will, in the long run, raise the resting point for nominal rates one for one, albeit after a period where rates will stay lower than they otherwise would have, to generate the stimulus necessary to hit the new target.
This said, the Fed Chair herself suggesting that the target might be changed amounts to the Fed moving the goalposts against which it is judged itself.
The current 2 per cent target was declared by the Fed, as a way of interpreting the price stability part of its mandate, set ultimately by Congress. The historical precedent was laid down, therefore, that Congress tolerates the Fed interpreting the otherwise vague mandate in this way. So perhaps a raising of this definition of ‘price stability’ stays within this precedent of a tolerated corridor of Fed independence.
Defining 4% to be ‘price stability’ would seem to be a stretch, at face value. Prices that are ‘stable’ surely do not go up by 4%.
Perhaps one could make the legalistic argument that if the rate of price increase is stable, this amounts to a kind of ‘price stability’. Or, in similarly technocratic terms, it might be pointed out that without the rise in the inflation target, which departs from ‘price stability’, there is less hope of meeting the other part of the dual mandate, which involves full employment, since this means more time at the zero floor to interest rates with fewer means with which to counter the business cycle.
After all, this was undoubtedly part of the calculation that led to Bernanke going for 2 per cent, and not a lower number. Even though the equilibrium real rate was much higher then, it was still recognised that the zero bound could be hit [there was the case of Japan] and that downward nominal rigidities in the labour market meant that a bit of inflation was needed to grease the wheels [and thus achieve full employment].
The broader context in which Yellen’s remarks were made is less encouraging. The Fed’s interventions with conventional and unconventional monetary policy, not to mention the bailouts, attracted the ire of the right in Congress.
A Fed initiated move to raise the inflation target – noting that conservatives often view inflation as expropriation – to permit more active Fed policy, would seem to be a hard sell to that part of US politics, which currently has the upper hand. Trump himself accused the Fed of conspiring to try to help the Democrats with loose monetary policy. Yellen’s remarks, seen in this context, might be predicted to re-ignite Congressional efforts to tame the Fed [remember the #AudittheFed campaign] and reduce its powers further.
Stepping back from the specifics of the US political and legislative context, it always seems to me unwise when central bank officials speak about choices that are essentially political. Since by intervening in this way they raise the chance of future incumbents being chosen using political criteria and to achieve political, and not necessarily economically beneficial ends.
But in her defence, Yellen may have calculated that she was not likely to be reappointed anyway, being seen as a legacy of the Obama era, and that the next appointment was inevitably going to be a highly political one, in which case the battle to retain that job for technocrats was effectively over, and the best one could do for the cause of better future Fed policy was to champion it explicitly.