Two Percent Inflation: A Good Thing Or A Bad Thing?

Maybe it’s just me, but it seems like every time Janet Yellen speaks publicly she goes out of her way to call attention to the FOMC’s two percent inflation target and remind us that she takes that target very seriously. She sincerely wants higher inflation for the good of the economy and she may be right to do so, but it makes me cringe.

When Ben Bernanke joined the Board of Governors the first time, he had a goal to implement an inflation target. Fortunately, from my point of view, Alan Greenspan never let that idea come to a vote. While I could sort of understand the academic case for positive inflation, in my gut I didn’t want to vote for inflation. Among other reasons, I didn’t want to have to explain such a vote to the folks back home. Fortunately, I was gone by the time it finally came to a vote during Mr. Bernanke’s later stint as Chairman.

I was reminded of that today as I looked over some promotional material on my broker’s web site, particularly a chart on how inflation destroys purchasing power. A graph showed what happens to the value of $50,000 after 25 years at a four percent inflation rate, a three percent inflation rate, and a two percent inflation rate. Hey, that two percent inflation rate was what the FOMC settled on as desirable. A two percent inflation rate—the Fed’s target—reduces the purchasing power of $50,000 to $30,477 in 25 years. That doesn’t look so benign to me.

One argument for a positive inflation rate is easy to understand, but I’m not sure it requires a rate as high as two percent. That is the argument that inflation might get so low that we accidentally slip into deflation. The Japanese experience has taught us that we don’t want to go there. But, wouldn’t one percent be a sufficient buffer?

Another argument that makes sense to central banker types is the “zero bound” argument. If you have three percent inflation, the central bank can push the policy rate down to one percent, which translates to a negative two percent in real terms. A zero nominal rate would be a powerful negative three percent with three percent inflation. But if inflation is zero, the real rate can be no lower than the nominal rate, hence the “zero bound.” We hear chatter that the ECB may be contemplating a negative nominal rate to deal with this problem.

Back in school I do vaguely recall discussions of inflation that went slightly beyond the superficial. I remember the point being made that the evils of inflation are really evils of unanticipated inflation—a surprise level of inflation. If the inflation rate is steady and anticipated, then other prices and incomes would adjust to it and remove most of the damage. The purchasing power of a dollar, or $50,000, would still be eroded by inflation but wages, incomes, and interest rates would also be higher as an offset.

Money illusion is involved if we prefer six percent wage increases during a period of three percent inflation to three percent wage increases with zero inflation, but money illusion may have its uses. For example, a high unemployment rate would be easier to remedy if wages could fall. It is easier for wages to fall in real terms if they don’t have to fall in nominal terms. Adjusting to changing competitive conditions internationally is likely to be easier if there is sufficient inflation to have flexible real wages despite inflexible nominal wages.

I’m sure that Ms. Yellen and Mr. Bernanke can explain the benefits of 2 percent inflation better than I can. I’m only glad I don’t have to. Besides, why couldn’t they have chosen one percent as a target?

Comments (7)

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  1. Andrea P says:

    I would agree with an inflation rate of two percent when the interest rates are higher than two percent. At least in some way you are capable of sustaining the value, in real, terms of your assets. It seems to me that pursuing a higher inflation than interest rates are going to make everyone worse off. We are not living in normal economic times, as the monetary policy being employed shows us, so we shouldn’t seek inflation goals that were thought in times of normal economic conditions.

  2. Bernard W says:

    If Mr. Bernanke campaigned for a two percent inflation rate while the economy was performing well, what makes them think that during weak economic times, we should aim for goals that were crafted under different conditions? I believe that what scholarly research says is blinding the FOMC from reality. They seem to forget that we are living in completely different times.

  3. Loius R says:

    Deflation has severely impacted the Japanese economy. They problem hasn’t been resolved and it is the major reason to why the nation stopped being the second most powerful economy in the world. The severity of the issues in Japan is due to an unfortunate chain of events. Not only did its economy suffered from deflation, which limits (inhibits) the effects of central bank’s monetary policy to fight it, but it occurred during the worst possible time. Technology boomed, which brought down prices across the board, furthering Japan’s crisis. Japan suffered from a lost decade and the country still fighting it. Considering Japan as an example, it makes sense why many central banks are pleading for inflation.

    • Martin H says:

      If you compare against the worst case scenario, it makes sense for people to be alarmed. But we must understand that what happened in Japan was the worst case scenario, something that perhaps will never repeat again.

  4. Miguel S says:

    Goldilocks effect? Too much inflation is bad, deflation is worse, and volatility is scary. There is a small range in which inflation is neutral, outside that fine range, we should be alarmed. There is no such thing as a just right amount of inflation; it all depends on the how the economy is doing. That is why we shouldn’t have a target, because the range moves depending on where the economy is located.

  5. Emanuel H Rosen MD says:

    Usually, when I (faithfully) read your posts, I breathe a sigh of relief that I now understand something I could not before. This time, actually, I feel validated in my lack of understanding. As the viral You Tube video “the Bernank” illustrates, though I know you don’t like that one :), it is hard for us hoi polloi to understand the goodness of 2% inflation. But if you, a scholar and an economist with real world authority, openly question the validity of this “Krugman brilliance level” assumption, then maybe, it is simply wrong, or more precisely an oversimplification of a complex economic ecosystem. Whenever the government tries to intervene to create this, it has unintended consequences worse than the perceived wrinkle it is addressing. Hmmm, sound familiar?
    Thanks again!

  6. Bob Neal says:

    I fear the government trying to regulate my life. Unintended ( or intended) consequences result from the complex economy adjusting to artificial pressures. Taxes are becoming more onerous, and are strangling us, since taxes are paid only by the consumer. I would like more control over taxes I have to pay. A consumption tax may well be the answer. But not VAT. The FairTax has been well researched, and has increasing popular support. The more I learn about it, the better I like it. It is transparent, simple, progressive, and relieves the lower-income of federal taxes.