The Fed strongly commits to the 2% inflation target. Should it aim higher?
China Finance 40 Forum

Editor's note: The China Finance 40 Forum (CF40) is a Chinese think tank specializing in issues of economic and financial policy. The article reflects the author's views and not necessarily those of CGTN.

On May 3, the U.S. Federal Reserve (Fed) announced the 10th rate hike since last March, bringing its benchmark borrowing rate to a target range of 5 to 5.25 percent, the highest since August 2007.

"Inflation remains well above our longer run goal of 2 percent," remarked the Fed Chair Jerome Powell at the press conference on the same day.

“Inflation has moderated somewhat since the middle of last year, nonetheless inflation pressures continue to run high and the process of getting inflation back down to 2 percent has a long way to go," he said.

Why has the Fed been so strongly committed to bringing inflation down to the 2-percent target? And should it consider setting a higher inflation target in view of its current economic situation?

The 2-percent inflation target has long been shared by the central banks of several of the world's major developed economies, such as the U.K., Japan, and Canada. 

However, in the decade after the 2008 financial crisis, inflation rates have almost never got back to below 2 percent. Later when the COVID-19 pandemic occurred, the U.S. introduced an extensive fiscal stimulus package coupled with quantitative easing programs, sending the inflation to a new high. Then, in an attempt to bring the inflation back to the target range, the Fed has launched an aggressive rate-hike campaign, which has caused wide-ranging spillover effects.

This begs the question: Is the long-embraced inflation target still viable in the current economic landscape?

"The world may be entering a period of persistent inflation," said Kenneth Rogoff, professor of economics at Harvard University and former chief economist of IMF, in his paper in February. He argues that the inflation rate will remain significantly above 2 percent, albeit not reaching double digits.

A number of economists associate the current high inflation expectation in the market with long-term structural factors, including a slowing globalization process, the shift to greener development, and rising labor wages. Economists believe that these factors would make it much harder for inflation to be cooled down to 2 percent, which, even if realized, would come at a substantial economic cost.

The Fed is now confronted with two unpleasant choices: crush growth and jobs to get to its 2-percent target, or publicly validate a higher inflation target and risk a new round of destabilised inflationary expectations, according to top economist Mohamed El-Erian.

As a matter of fact, the debate over whether to raise the inflation target has been going on for years.

Those who support the idea believe it is better to maintain inflation at around 3 or even 4 percent. They argue that this would leave the central bank more room for action in the event of an economic crisis.

The opponents reject the idea on the basis that raising the target would result in more frequent changes in prices and wages, therefore rendering the monetary policy less effective. There is also the worry that there will lack room for the Fed to act during a serious economic recession.

More importantly, changing the inflation target could hurt the credibility of central banks, especially doing so at a time when the inflation is still running high.

It seems like the Fed is caught in a dilemma. Fortunately, there may be some kind of compromise that it could adopt.

What could be happening is that although the Fed is publicly signaling a 2-percent target, it could instead pursue a higher number and hope the public accepts it, said Mohamed El-Erian.

Eventually, regardless of whether the Fed tolerates a higher target in practice, it will still have to take a firm public stance on the 2-percent target at the moment, as this is necessary to fight the persistently high inflation. It is only when the inflation eases that the time comes for it to take a long hard look and make moves to raise the inflation target.

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