No, we don't need to tolerate higher inflation

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Inflation is finally falling. Although the year-over-year inflation rate is still over 4%, well above the Federal Reserve's 2% target, much of that reflects especially large price increases from last summer. As those unusual months cycle out of the data, the rate will likely keep dropping.

With inflation trending down, but not yet at target, some notable economists including Nobel laureate Paul Krugman and Moody's Analytics' Mark Zandi have questioned whether the Fed should even worry about the target. In their view, getting all the way down to 2% could threaten the strong labor market. This is not a new perspective. Over the years, many economists have argued that a slightly higher inflation target could actually be a good thing.

We should reject these arguments. A higher target is harmful and unnecessary for the Fed to do its job of promoting full employment and price stability.

The idea that higher inflation would be good might sound strange. Why would some economists want this, especially after the painful price increases of the past two years? The main reason has to do with what we call the "Fisher effect." When lenders set interest rates, they want to make sure that devalued dollars don't effectively reduce their profits. Thus, nominal interest rates (interest rates we observe in reality) adjust for inflation. A higher inflation target leads to higher nominal interest rates.

To mitigate recession, central banks like the Fed typically cut short-term interest rates. To reduce inflation, they raise rates. From the Great Recession through the 2010s, however, many central banks faced nominal interest rates near or close to zero. Not being able to take rates much lower makes monetary policy more difficult. Economists like Krugman argue that higher inflation targets would give central banks extra wiggle room to combat recessions.

But even if higher inflation is targeted and planned for, it comes with costs. First, people who prefer to hold cash are penalized as its value falls. Even in our increasingly "cashless" economy, a recent Fed study shows that U.S. consumers still use cash for nearly 20% of payments. Second, high inflation raises the capital gains tax burden, as these taxes are not indexed to inflation. This discourages healthy savings and investment. Third, firms need to raise the prices they charge more frequently to keep up. Economists call these "menu costs," because restaurants reprinting menus serve as an excellent example.

There is a much better alternative to a higher inflation target. Instead of targeting the inflation rate to begin with, the Fed should simply target total spending in the economy, or nominal GDP (NGDP). NGDP growth is the sum of real growth in the economy plus inflation.

If NGDP falls below path as it did in 2008 and 2020, the Fed would pursue a more expansionary policy — think cutting interest rates and injecting more money into the economy — to bring NGDP back up. On the other hand, if NGDP rises too high like it has recently, the Fed would pursue a more contractionary policy — think raising interest rates and taking money out of the economy — to bring NGDP down.

Unlike inflation targeting, NGDP targeting allows the inflation rate to change in response to supply factors. For example, events like the Russia-Ukraine war are negative supply shocks which reduce productivity and raise prices. An NGDP-targeting Fed would tolerate this temporary rise in prices. But with inflation targeting, the Fed responds by cooling off the economy — an economy already being weakened by the shock.

Likewise, a positive supply shock like a productivity boom will lower prices. An NGDP-targeting central bank will allow these prices to fall. An inflation-targeting central bank will artificially overstimulate the economy to keep prices up, leading to an unsustainable boom.

We've been hearing a lot about inflation rates for the last few years. Maybe it's time to talk about something else.