The Federal Reserve did not only vow to maintain a zero interest-rate policy through the end of 2014 (a policy that has its critics, incidentally). They also set an explicit interest rate target for the first time ever, as far as I can tell.
The Federal Reserve took the historic step on Wednesday of setting an inflation target, a victory for Chairman Ben Bernanke that brings the Fed in line with many of the world’s other major central banks.
The U.S. central bank, in its first ever “longer-run goals and policy strategy” statement, said an inflation rate of 2 percent best aligned with its congressionally mandated goals of price stability and full employment.
However, it said it was not appropriate to adopt a fixed goal for employment because the level of unemployment that can be achieved without sparking inflation is not largely determined by monetary factors.
The inflation target is at the high end of what was traditionally seen as an informal target range of roughly 1.7 percent to 2 percent. It caps a long crusade by Bernanke to open a window onto what for years had been the Fed’s purposefully opaque and secretive deliberations.
Two things: I think they could easily have set a natural rate of unemployment (commonly referred to as a NAIRU), and that they didn’t kind of shows you the Fed’s priorities, more on inflation than unemployment. But the bigger issue is that this 2% target is too small at this point, as Paul Krugman explains.
[…] the inflation hawks are still a powerful force that must be appeased. But the truth is that recent experience has made an overwhelming case for the proposition that the 2 percent or so implicit target prior to the Great Recession was too low, that 4 or 5 percent would be much better. Even the chief economist at the IMF says so. (OK, in real life it’s Olivier Blanchard, who is a very smart and also flexible-minded macroeconomist who just happens to be at the IMF for now — and I’m glad that he is!)
The thing is, if we’re going to lock in a formal inflation target, now would be a good time to get it right, instead of waiting until the memory of the crisis fades and everyone gets complacent again.
Even with the 2% target you can see problems here. The Fed forecasts long-term inflation at between 1.7% and 2%. Core inflation in the past year was around 1.7%. But if it were 2.3%, that would miss the target by the same amount. Yet at 2.3%, all the policy elites would say that the Fed had failed. They do not say that at 1.7%. And that’s how the target becomes a ceiling. Which is bad policy, especially in a time of economic fragility.