Project Syndicate asked Mike Boskin, Brigitte Granville, Ken Rogoff and me whether 2% is the right inflation target. See the link for the other views. I pretty much agree with them in the short run -- don't mess with it -- but took a different long run view. Apparently Volcker and Greenspan were fans of price level targeting and hoped to get there eventually, which is the sort of long run approach I took here.
I also emphasize that any inflation target is (of course) a joint target of fiscal as well as monetary policy. Fiscal policy needs to commit to repay debt at the inflation target.
My view:
No, 2% is not the right target. Central banks and governments should target the price level. That means not just pursuing 0% inflation, but also, when inflation or deflation unexpectedly raise or lower the price level, gently bringing the price level back to its target. (I say “and governments” because inflation control depends on fiscal policy, too.)
The price level measures the value of money. We don’t shorten the meter 2% every year. Confidence in the long-run price level streamlines much economic, financial, and monetary activity. The corresponding low interest rates allow companies and banks to stay awash in liquidity at low cost. A commitment to repay debt without inflation also makes government borrowing easier in times of war, recession, or crisis.
Central banks and governments missed a golden opportunity in the zero-bound era. They should have embraced declining inflation, moved slowly to a zero-inflation target, and then moved gently to a price-level target.
Why not? Some focus on the short run and say that central banks should raise the inflation target, because getting inflation to 2% will require too much pain in the form of unemployment. But inflation is falling alongside very low unemployment, proving this argument wrong again. And shifting the goal posts undermines the stable expectations that allow relatively painless disinflation.
The other argument says that a higher inflation target creates more room to use rate cuts to stimulate the economy in times of recession. But that is like wearing shoes that are too tight all day, because it feels so good to take them off at night. This argument presumes that expected inflation is set mechanically by previous experience. Moreover, the evidence that slightly lower overnight rates provide much stimulus is weak. The potential benefit is not worth permanently abandoning a stable value of money.
Update:
Many comments here and on twitter ask about a nominal GDP target. I'm not a fan, for three reasons.
First, just what does the Fed do to hit a nominal GDP target? That objection is common to the price level target, but it's an important point. Nominal GDP targeting advocates seem to think it solves the whole conundrum of just how do interest rates affect inflation. No, it's just a different centering point of the Taylor rule. Raise interest rates if nominal GDP growth is high, lower it if low.
Second and more to the point, it assumes that "potential," "supply" or "neutral" real GDP growth is constant or at least slow moving and known. If potential grows 2% real and you want 2% inflation, then the nominal GDP growth target is 4%, and the idea is that you let the economy take care of the split between real and nominal in the short run. I'm of the view that there is a lot more high frequency movement in "potential" than commonly thought, so even if the Fed achieved steady nominal GDP growth, there would be needless inflation volatility or needless deviation from neutral real growth. Real GDP grew 4% 1950-2000 and 2% since then. How long does it take the target to adapt to this sort of thing?
The idea is that the Fed isn't smart enough to separate nominal GDP growth to real growth and inflation, so let that be endogenous. Of all the problems of monetary policy, this doesn't seem like the worst to me.
Third, I like the clarity of a price level target. Even if you make it level, not growth, of nominal GDP, it's muddy just how much inflation you should expect when borrowing money, financing a project, etc. Keep the units pure. Moreover, if you don't like price index measurement issues, wait until you look in to GDP measurement issues. GDP is not consumer surplus.
Others ask what about mismeasurement. Answer: fix the measurement.
Back to, just what does the Fed do differently? Presumably, the Fed raises interest rates when nominal GDP is higher or growing faster than target, and vice versa. That's awfully close to a Taylor rule.
Take a nominal GDP growth target. Then the Fed would follow interest rate = a + (coefficient) * (inflation + real GDP growth - target). That's the same as interest rate = a+ (coefficient) * (inflation-inflation target) + (coefficient) *(real GDP growth - its target). So, we're just arguing about whether the inflation and GDP coefficients should be the same -- the Taylor rule is 1.5 and 0.5 -- and whether to use growth or gap. Other versions are just other modifications of the Taylor rule.
It's not magic. There is nothing about a nominal GDP target that makes the Fed any more able to hit it than it does an inflation target.
The main argument for targeting the level of NGDP is that it enforces forward guidance. In the 2010s, the Fed was searching for was to promise it would keep interest rates low for a long time, and allow inflation to surge in the future. NGDP, as to a lesser extent a price level target does that. However, so did the Fed's new strategy. The Fed waited an unprecedentedly long time to raise rates, and in the view that raises inflation, they did their job. NGDP is right back on the pre 2007 track. Would the NGDP target have been more effective a promise than the flexible average inflation targeting? Maybe, but it's just a different flavor of the same thing.
Meanwhile, the big missing question is just whether low interest rates raise future inflation at all. We're sitting on the roadside in Iowa, with a blown tire, and discussing whether we want to go to Disneyland or Universal studios first.
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