Q: Everyone is talking about the central banks getting back to the ideal target of 2 percent inflation. Why not 0 percent inflation?

James

A: Art Rolnick, the former head of research at the Federal Reserve Bank of Minneapolis, used to say there was nothing magical about 2 percent. The economy could work just fine with 7 percent consumer price inflation or 9 percent inflation so long as the rate was stable.

The Fed hiked its benchmark interest rate last week since the central bank is convinced that the economy is strong enough that inflation will eventually return to the desired rate of 2 percent. The Fed wants to keep inflation expectations stable even though consumer inflation is running below its target rate.

Why 2 percent? Former Fed Chairman Ben Bernanke made the 2 percent inflation rate goal explicit, arguing that the rate best reflected the central bank’s dual mandate of long-term price stability and full employment. Higher rates of inflation simply sound scarier and, in practice, higher inflation rates often translate into volatile inflation rates. Two percent inflation greases the skids of commerce by allowing for modest pay raises and price increases. Two percent inflation leaves central banks room to adjust to changes in the economy.

Zero inflation limits central bankers’ room to maneuver. Central banks can’t easily reduce interest rates below zero. A zero rate of inflation boosts the odds that the Fed will resort to extraordinary measures in the face of a nasty recession — like the Great Recession. It also puts the economy uncomfortably close to deflation or falling prices which, among other things, makes debt more expensive, companies less profitable and more likely to lay off workers.

Here’s the thing: The consumer price index has met or exceeded the 2 percent target just a quarter of the time over the past two decades. Perhaps the combination of technological advances such as hydraulic fracturing, the rise of online commerce and the spread of mobile phone applications have created a stubbornly low price environment. Central bankers worldwide share a commitment to keeping inflation contained. Taken altogether, people still seem to believe that the U.S. has landed on something close to long-term price stability.

To be sure, there will be periodic inflation scares and actual spikes in consumer inflation rates. But for financial planning purposes, assuming a long-term consumer price inflation rate of 2 percent is a reasonable expectation

 

Chris Farrell is senior economics contributor, “Marketplace,” commentator, Minnesota Public Radio.