“Bad Options” Regarding 2% Inflation Targets (And Other Silly Notions)

The Wall Street Journal and Bloomberg both posted ridiculous articles regarding today regarding inflation.

The former was on “bad options” the latter on “inflation expectations”.

Let’s take a look at both articles because both represent widely believed nonsense.

In Bad Options for Addressing Too-Low Inflation, Wall Street Journal writer Greg Ip says the Fed’s choice is to overheat the economy or give up its 2% target.

Unemployment and inflation are near their lowest levels in decades. Who wouldn’t love that?

Janet Yellen, for starters.

What looks like a dream economy could be a nightmare for the Federal Reserve chairwoman. Ms. Yellen’s worldview assumes that when unemployment is this low—4.4% in August—inflation should move up to the Fed’s target of 2%. Instead, it may have stabilized around 1.5%. That presents the Fed with some unpalatable options: deliberately overheat the economy for years to get inflation back up, then potentially induce a recession to stop it from overshooting; or give up on the 2% target, which could hobble its ability to combat future recessions.

This isn’t scaremongering: It’s the logical consequence of how central banks believe inflation operates. At the center of their model is the Phillips curve, according to which inflation edges lower when unemployment is above its natural, equilibrium level and putting downward pressure on prices and wages. Below that natural rate, also known as full employment, inflation crawls higher.

Until recently, Fed officials scoffed at the possibility [Trend inflation has fallen]. They noted surveys that suggest the public still expects inflation to return to 2% and credit their oft-repeated promise to hit their 2% target. But are they fooling themselves? Expectations of inflation are determined in great part by what inflation actually has been, and after every recession since 1982, core inflation has averaged less than in the previous business cycle: 4.1% in the 1980s, 2.1% in the 1990s, 1.9% in the 2000s, and 1.5% since 2009.

To get inflation higher, the Fed would have to engineer the opposite of the past 35 years: a prolonged boom that drives unemployment below its natural rate until inflation returns to 2%. As actual inflation rises, so would expectations, locking in the higher trend. To achieve this, Ms. Brainard suggests interest rates shouldn’t rise much more, if at all.

This approach could aggravate another worry: financial excess. If stocks and property look bubbly now, imagine what five more years of very low interest rates would do.

The alternative is to ditch the 2% target and accept 1.5% as the new inflation trend. Besides shredding the Fed’s credibility, that would mean lower trend interest rates and thus less rate-cutting ammunition to fend off the next recession. If history is any guide, that recession would push trend inflation down further.