2% wasn’t an ‘arbitrary number’ Neel

FOMC member Neel Kashkari has been doing battle with the crypto gold bugs on Twitter.  In the cut and thrust of this debate, he let fly that the 2% target the Fed had set itself was an ‘arbitrary number’.

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I mostly disagree with this.

2% was a round number that weighed up various factors bearing on the optimal inflation rate for a central bank.

First, the Friedman Rule:  inflation erodes the value of money, forcing people to economise on it, and suffering inconvenience as a result.  [The FR actually implies on its own setting the target at minus the riskless real rate of interest].

Second, the costs of re-posting prices [known as ‘menu costs’ imagining restaurants reprinting their menus].

Third, the fact that inflation measures tend to overstate true inflation [because of inadequately taking account of quality improvements, changes in the goods mix, and changes in the mix of outlets that sell them].

Fourth, how positive inflation helps bring about falls in real wages in some sectors where there might be downward nominal rigidity.  [If you are in a poor performing sector, or managing poor performing workers, you may be able to lower real wages simply by not increasing the wage in £s].

Fifth, the benefit of keeping nominal interest rates [which will tend to rise one for one with the inflation target] above the zero bound, to provide for decent size cuts at the onset of a recession.

This latter benefit we have learned more about.  We know that the risk of hitting the bound is greater than we presumed then in the late 80s and early 90s.  And we now have more experience operating unconventional monetary policy tools which can be used as a substitute for interest rate policy.

I say ‘mostly disagree’ because I doubt that there was any particularly scientific quantification of these things in the determination of the actual number.  A lot of that went on after the event.  But these arguments were common currency among academic and central bank economists, and those at the top of the Fed and other central banks would have known them.

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