Why is the Fed's target inflation rate 2%

[bizerta]

This could also be a GQ or a GreatDebate. Why is the Fed’s target inflation rate 2%? Why isn’t it zero? A 2% rate means prices double every 35 years. Wouldn’t it be easier to compare wheat’s price today to wheat’s price in 1980 if prices remained the same?

As a secondary question … Who benefits from inflation? The first answer out of most people’s mouths is “borrowers” because they have to pay back with cheaper dollars. But lenders aren’t dummies. They know that their dollars will buy less when the loan is repaid so they charge more interest. 50 years ago, with 2% inflation, a typical mortgage was 6%. Today, with trivial inflation, mortgages are 4%.

[Ludovic]

It will give some leeway that will prevent deflation. Better to have a tiny bit of inflation than risk deflation, under which people will be reluctant to spend any money because the same thing will be cheaper a few months from now.

[iamthewalrus_3]

No, lenders aren’t dumb. But wage-earners are (sort of).

One major case for having some inflation usually has to do with the psychology of wage stickiness.

In a downturn, the optimal thing to do is for everyone to take a small pay cut, and keep on working. This is a bummer (no one likes pay cuts), but it’s generally not disastrous.

But it turns out that people really don’t like pay cuts. The morale impact on your employees is huge, because getting a pay cut feels like someone telling you you’re bad at your job. It also kind of feels like your company is spiraling down the tubes, and maybe the best employees decide to go find another job. Even in a recession, there are people who are more valuable than they’re being paid, and if cutting their pay spurs them to look elsewhere, that’s bad news for a company. All in all, the psychological impact of broad pay cuts is big enough that it’s pretty rare for it to happen. Maybe in some small companies, where people have a strong personal connection to each other and can feel like they’re all pitching in to keep the ship afloat. But in most companies, it’s pretty much a non-starter. This resistance to lowering wages is called “wage stickiness”.

So what actually happens is that instead of, say, everyone taking a 5% pay cut, a few people get laid off. This is slightly better for the people who keep their jobs, but it’s disastrous for the people who lose them, and for the economy as a whole. Unemployment is way worse than lower pay, both because the skills and self-worth of the unemployed degrade, and because, in a very real way, there’s less stuff being accomplished. If everyone building roads or writing sonnets or assembling widgets is paid a bit less, we still have just as many roads and sonnets and widgets (wealth creation!). If you lay off 5% of them, well, we probably get fewer of all those things. And a lot more depressed people watching TV and spending a lot of time in other not-very-productive ways. And it’s more likely to have positive feedback, since the people who get laid off will severely restrict their spending, which then lowers overall demand even more, which causes more people to be laid off. Pay cuts don’t have

So, you can’t effectively cut pay, and the other way to reduce labor costs (layoffs) has really bad effects. Inflation to the rescue. Just stop giving people raises, and their real wages will slowly drop. Effectively, every year you don’t get a raise, you’re getting an inflation pay cut. But people don’t see it that way (as long as inflation is pretty low). We think in nominal values, not real ones. People are not fully rational beings, and it turns out that minor inflation effectively counteracts some of the most irrational bits of nominal wage stickiness.

[mbh]

Defining inflation is rather tricky. There is no single statistic that works for every situation. Compare 1950 to today. Gold is a lot more expensive, computers are a lot cheaper. What truly measures the inflation from then to now?

The Consumer Price Index seems to work pretty well for the most people’s purposes. Most economists believe that the CPI overstates inflation by approximately 2%. So the Fed tries to achieve 2% CPI, which (hopefully) corresponds to stable prices for the average consumer.

[wevets]

@mbh

The Consumer Price Index seems to work pretty well for the most people’s purposes. Most economists believe that the CPI overstates inflation by approximately 2%. So the Fed tries to achieve 2% CPI, which (hopefully) corresponds to stable prices for the average consumer.

Do you have a cite? The wikipedia article says nothing of the sort.
It especially doesn’t make sense as another large-scale measure of inflation, MIT’s Billion Prices Project “tracked the CPI closely” according to the Washington Post:

@http://www.washingtonpost.com/wp-dyn/content/article/2010/12/25/AR2010122502600.html

The BPP’s inflation measure is markedly different from the government’s. The economists average all the prices culled online, meaning the basket of goods is whatever you can buy on the Web. (Some items, like books, are most often bought online. Others, like cats, are not.) Plus, the researchers do not weight certain items’ prices, even if they tend to make up a larger proportion of household spending.

Still, thus far, the BPP has tracked the CPI closely. And the online-based measure has additional advantages. It comes out daily, giving a better sense of inflation’s direction. It also lets researchers examine minute, day-to-day price changes. For instance, this month Roberto Rigobon and Eduardo Cavallo noted that Black Friday discounts “had a smaller effect on average prices in 2010 than in 2009,” contrary to reports of deeper discounting this year. And it has already produced some academic insights. For instance, Cavallo found that retailers change prices less often, but more, percentage-wise, than economists previously thought.

Fed targeting of 2% inflation has to do with optimizing inflation measured by the CPI, not as some sort of adjustment against errors in the CPI.

We can also know this because the Fed itself tells us that’s not true:

@http://www.federalreserve.gov/faqs/economy_14400.htm

The Federal Open Market Committee (FOMC) judges that inflation at the rate of 2 percent (as measured by the annual change in the price index for personal consumption expenditures, or PCE) is most consistent over the longer run with the Federal Reserve’s mandate for price stability and maximum employment. Over time, a higher inflation rate would reduce the public’s ability to make accurate longer-term economic and financial decisions. On the other hand, a lower inflation rate would be associated with an elevated probability of falling into deflation, which means prices and perhaps wages, on average, are falling–a phenomenon associated with very weak economic conditions. Having at least a small level of inflation makes it less likely that the economy will experience harmful deflation if economic conditions weaken. The FOMC implements monetary policy to help maintain an inflation rate of 2 percent over the medium term.

[excavating_for_a_mind]

@Ludovic

It will give some leeway that will prevent deflation. Better to have a tiny bit of inflation than risk deflation, under which people will be reluctant to spend any money because the same thing will be cheaper a few months from now.

This.
Inflation encourages economic consumption, which, in turn, encourages economic expansion. A small level of inflation is stable.

Deflation, however, discourages economic consumption. If a new car is likely to be cheaper next year, more people are going to hang onto their old car another year. People aren’t going to sign onto a 30-year mortgage if the property is going to be worth only 60% in 30 years. Deflation, even at a small level, is unstable as it can put the brakes on an expanding economy.

[septimus]

@bizerta

Why is the Fed’s target inflation rate 2%? Why isn’t it zero? … Wouldn’t it be easier to compare wheat’s price today to wheat’s price in 1980 if prices remained the same?

Others have explained why inflation might help the real economy. I think you will find more competent economists arguing for 4% inflation today than would argue for zero. Do you honestly think that the convenience of comparing prices with those 30 years ago would outweigh the economic benefits? :rolleyes: (I think there are Javascript webpages that will let you do such comparisons easily if you need them.)

But kudos to OP !! At least he didn’t adopt the YouTube goldbug fantasy that inflating $2 trillion to $4 trillion somehow confiscates $1 trillion of the people’s money. :smack: (When pressed about where the $trillion went, the HyperLibertarian YouTubers usually mumble something about the Rothschild/New World Order vaults in Switzerland. :eek: )

@bizerta

As a secondary question … Who benefits from inflation?

Best is to distinguish expected (i.e. predictable) inflation from unexpected inflation. The Fed-imposed inflation is very much expected. The Fed announces its inflation target and moves toward it gradually.

With expected inflation, neither borrowers nor lenders are significantly hurt – nominal interest rates adjust to keep real interest rates at an appropriate market level.

Because financial institutions often get, effectively, a commission on interest, the move away from zero interest rates will create more profit opportunity for U.S. banks. As if they needed it.

[mbh]

@wevets

Do you have a cite? The wikipedia article says nothing of the sort.

My cite is a professor in an undergraduate class I took 25 years ago.

Your Fed quote does not contradict this:

2 percent (as measured by the annual change in the price index for personal consumption expenditures, or PCE) is most consistent over the longer run with the Federal Reserve’s mandate for price stability [underscore added for emphasis–mbh]

@bizerta

As a secondary question … Who benefits from inflation?

Economists have traditionally preferred modest inflation rather than any deflation. Conventional wisdom holds that, in the long run, wages rise faster than prices. This was true for the USA through most of the 20th Century. Most people believe the trend will continue. (The goldbugs disagree.)

[wevets]

@mbh

My cite is a professor in an undergraduate class I took 25 years ago.

Your Fed quote does not contradict this:

2 percent (as measured by the annual change in the price index for personal consumption expenditures, or PCE) is most consistent over the longer run with the Federal Reserve’s mandate for price stability [underscore added for emphasis–mbh]

Nowhere in that quote or in other Fed literature does it say that CPI is consistently overestimating inflation by 2%.

If this were true, then when the Fed misses its inflation target too low, then there would be no inflation, and we would experience deflation (I think we can agree the chances of getting an inflation rate of exactly zero for any significant period of time are astronomically unlikely.) In a natural experiment, the Fed has missed its inflation rate target since mid-2009 for every month except December 2011-March 2012, yet the independent Billion Prices Project shows inflation from November 2009 through January 2015 and the CPI (link is raw annual, not seasonally adjusted) shows no deflation in that period either.

[Ruken]

Here is BLS’ take on CPI, including common complaints.
http://www.bls.gov/opub/btn/volume-1/mobile/consumer-price-index-data-quality-how-accurate-is-the-us-cpi.htm

[wevets]

Thanks for that link, Ruken, that’s a very helpful and informative summary of errors in CPI measurement of inflation.

[Ruken]

@wevets

Thanks for that link, Ruken, that’s a very helpful and informative summary of errors in CPI measurement of inflation.

I’m still interested in an analysis that addresses their points and still disagrees, but I don’t see anything yet.

[wevets]

The conclusion the authors reach in your cite is pretty solid:

Conclusion

Measurement of price change in a large economy is sufficiently complex that the accuracy of an estimate is difficult to gauge and is likely to be debated. The CPI cannot claim to be a completely precise measure of inflation and publishes the variance of its estimates. Several potential sources of bias have been identified in the CPI and addressed, though there continues to be debate over to what extent and in what direction bias may still exist and the ways in which BLS can continue to increase accuracy.

I’m not sure you’ll find anyone who would argue that CPI is a precise measure of inflation or that it does not have biases - I doubt there are any precise measurements in economics the way there are in, say, anatomy.

I personally think the Billion Prices Project is a great way to address some of the upward biases in CPI and hope there will some sort of technique synthesis that will allow the vast increase in the CPI “basket” as online price information becomes more comprehensive, making some of the biases inherent in basket selection moot.

Not sure why anyone would believe the downward biases in CPI were so consistent that the Fed could target inflation off the magnitude of the bias though, that just sounds bizarre.

[bump]

Next you’ll be asking why economists think that a 0% unemployment rate is bad as well…

[Scylla]

The Fed has a positive target rate for inflation, because economic theory says that it’s necessary wit a fiat currency.

Consider a pure barter economy. If you have pigs and you want sweaters and the guy that has sweaters doesn’t need pigs, but instead wants wood, than you have to check with the guy who has wood to see if he will trade some for pigs so you can trade the wood for a sweater. Chances are it’s not going to be one pig equals one board of wood equals one sweater either. You will get stuck with either excess pig, or excess wood when you go to trade your pig.

So, it’s really nice to have something like cash lets us take care of all these details and niceties efficiently. We sell our pigs and we buy what we want with the cash and the problems of barter goes away.

Currency is clearly useful. This is another way of saying it has value. It provides a service, namely providing liquidity.

$100 worth of pigs and $100 cash are theoretically of equal but the pigs aren’t easily exchangeable for other things the way the cash is. The pigs don’t have that value that cash has. Therefore $100 worth of cash is more valuable than $100 worth of pigs.

Since cash is intrinsically more valuable than the things it can buy, there is a natural tendency to hoard that cash and not buy things with it. If everybody is hoarding their cash and not using it than that defeats its purpose as a medium of exchange.

Therefore $ needs to be a little bit of a hot potato. You have to feel that you need to spend it. A way to do this is to make it slowly decrease in value. For example, if instead of buying 100 pigs with your money today, you sit on it for a year then that money only buys 98 pigs. The cost of waiting was 2 pigs.

Inflation helps a currency attain its goal of being a fluid medium of exchange by incenting people to spend it on goods and services.

That’s sort of a primer on inflation and monetary theory. There’s a lot more to it, but basically all sorts of really bad things start to happen if there is not some inflation in a currency.

[Stringbean]

It’s the happy medium between deflationary hell and inflationary purgatory.