The Fed’s 2% Inflation Target
Good for the Rich, Not the Rest of Us
This article is from Dollars & Sense: Real World Economics, available at http://www.dollarsandsense.org
This article is from the
March/April 2023 issue.
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“My colleagues and I understand the hardship that high inflation is causing, and we are strongly committed to bringing inflation back down to our 2 percent goal. Without price stability, the economy does not work for anyone. In particular, without price stability, we will not achieve a sustained period of labor market conditions that benefit all.”
—Transcript of Federal Reserve Chair Jerome Powell’s Press Conference, February 1, 2023.
At his February 2023 press conference, Jerome Powell, the chair of the Federal Reserve Board, announced that the Fed had raised short-term interest rates for the eighth time since March 2022. The Fed boosted the Fed Funds rate on overnight lending by commercial banks by a quarter of a percentage point to 4.75%, its highest rate in 15 years. The Fed’s move in turn pushed up other interest rates, including mortgage rates, business loan rates, and new car loan rates.
Powell began his remarks by letting us know that he and his colleagues on the Fed committee that voted in February to increase the Fed funds rate feel the pain we’ve endured under the “hardship of inflation.” He then promised that they remain “strongly committed” to bringing inflation back down to the Fed’s 2% target rate. And he assured us that the Fed’s pursuit of price stability will allow for “a sustained period of labor conditions that benefit all.”
Powell must have felt better after getting all of that off his chest. But you shouldn’t. The Fed’s pursuit of its 2% inflation target will slow economic growth, repress wage gains, make almost everyone’s job less secure, and put us at risk for a recession.
Nor is there reliable evidence that the Fed’s policy of raising interest rates to push inflation rates down to the Fed’s 2% inflation target will promote economic growth even over the long term. What is clear, however, is that the Fed’s monomaniacal pursuit of its 2% inflation rate will widen the difference between the rich and the rest of us. This target will protect corporate profits and stock market returns while undermining the conditions that are necessary for the “sustained period of labor conditions that benefit all” that Powell promises.
What’s below endeavors to explain the conflict between the belief of the Fed—and of most establishment economists—that the Fed’s monetary policies ultimately provide widespread benefits, and the empirical evidence that, in practice, the Fed’s monetary policy exacerbates inequality as it keeps a lid on sustained economic growth that could empower those who work for wages.
A Dubious Target
The inflation story of 2022 was a tale of two quite different inflation rates. The Consumer Price Index (CPI), the most widely reported measure of inflation, rose at a 2.8% annual rate from June through December 2022, far less than the 10% CPI annual inflation rate for January through June 2022. The monthly inflation rate picked up some in January 2023. But the CPI inflation rate still averaged just a 3.3% annual rate from July 2022 through January 2023. (See Arthur MacEwan, The Inflation Reality and the Attack on Wages for more on the 2022 inflation rates.)
Despite the dramatic drop in the inflation rates, which Powell begrudgingly acknowledged as “a welcome reduction in the monthly pace of increases,” in February the Fed once again raised interest rates. The interest rate hike was intended to slow spending and economic growth, which in turn would slow job creation and keep wage gains in check. And in the wake of the January inflation figures, the presidents of the Cleveland and St. Louis Federal Reserve Banks were already publicly lobbying the Fed for larger interest rate increases, of one-half a percentage point or more.
Nor is the Fed alone in its pursuit of a 2% inflation target. The central banks of Australia, Canada, the euro area, Japan, and the United Kingdom also operate with a 2% inflation target. (See box.)
The Kiwi Inflation Target Goes Viral
The 2% inflation target came into being with little or no theoretical or empirical justification. Facing a 10% inflation rate in the late 1980s, New Zealand’s Finance Minister Roger Douglas told a television interviewer that the government would set an inflation target of zero to convince the public that its anti-inflation measures would persist. The next year, with the opposition leader hospitalized and Christmas around the corner, parliament made a zero to 2% inflation rate the official target of the Reserve Bank of New Zealand. In the mid-1990s the Fed and other central banks began to adopt New Zealand’s 2% inflation target with little more economic consideration than Douglas had given the target to begin with. Nonetheless, a 2% inflation target was to their liking. It was compatible with what most economists learned in graduate school, as I did, about how lowering inflation rates would not reduce economic growth over the long run. And a 2% inflation target was low enough to please the Fed’s constituents, banks and financial institutions, but not so low as to flirt with deflation and declining prices, which would damage the economy.
In their paper presented at the December 2022 Political Economy Research Institute (PERI) conference on “Global Inflation Today,” economists Robert Pollin and Hanae Bouazza found “no serious body of research” that justifies a 2% to 3% inflation target. In their own research, Pollin and Bouazza examined the relationship between inflation rates and economic growth (corrected for inflation) of 130 countries at all levels of economic development from 1960 to 2021. They show that during years that the inflation rates in these countries were near the Fed’s 2% target these economies grew more slowly than during years with somewhat higher inflation rates. For their full 130-country sample, in years when inflation rates were less than 2.5% (and greater than 0%) the median (or middle) growth rate was lower than that during years with inflation rates between 2.5% and 5%, as well as during years with inflation rates between 5% and 10%. The same result held for a group of 37 high-income countries. During the same time period, in the U.S. economy the median growth rate was 2.7% a year when the inflation rate was between 0% and 2.5%. The median growth rate in the U.S. was 3.6% for the years when the inflation rate was between 2.5% and 5.0%, and it was 3.1% in years with inflation rates between 5% and 10%.
Their empirical evidence shows that the Fed’s 2% inflation target is associated with slowing down, not speeding up, economic growth. And slower growth moves us further away from, not closer to, economic conditions that could provide widespread sustained benefits.
A Wealth-Protection Racket
Powell and his colleagues might well believe that the Fed’s 2% inflation rate will create widely shared economic benefits. Economic policymakers that see the economy through “finance-colored” glasses, as economist Jane D’Arista once put it, and whose primary constituents are banks and financial institutions, might well see the benefits of an inflation-obsessed monetary policy as widespread.
But, in practice, a 2% inflation rate target acts first and foremost to protect the wealth of the rich from being eroded by inflation. In their paper presented at PERI’s December 2022 conference on global inflation, economists Aaron Medlin and Gerald Epstein argue just that. To make their case, they document the close relationship between the wealth gains of the richest 1% and 10% of households in the United States and inflation rates. (Wealth includes financial assets, e.g., bonds or stocks, and nonfinancial assets, such as a house, a business, or a car, minus debt, corrected for inflation.) In high-inflation periods such as the 1960s and 1970s, the wealth holdings of the top 1% stagnated, but then grew substantially in the next four decades, increasing by an average of more than fourfold (corrected for inflation) from 1980 to 2022.
Beyond that, Medlin and Epstein unravel how Fed policies intended to lower inflation rates, by raising interest rates and slowing economic growth, can protect the value of large wealth holdings. Fed policies dramatically reduced but didn’t eliminate the damage that would be done to the wealth of the top 1% (and the top 10%) with continued high inflation rates. Higher interest rates decrease the market value of long-term securities. Higher interest rates also reduce borrowing to buy financial assets, which decreases the demand for and price of stocks and bonds. At the same time, higher interest rates slow the economy, dampening the outlook for future profits.
Nonetheless, Medlin and Epstein estimate that if the Fed had sat on its hands and done nothing to bring down the high inflation rates, the damage to wealth holdings would have been even greater and lasted longer. In their study they found that a 6% inflation rate would have reduced the value of the wealth holdings of the top 1% by 30% over three years, since higher inflation rates would erode their value. TThat was nearly twice the damage that would have been done by a 16% reduction to their wealth holdings if the Fed had lifted interest rates by 3.75 percentage points. Their study suggests that for every percentage point the Fed increased interest rates, the inflation rate would fall by 2% in three years’ time.
With those kinds of policies, the Fed has widened the difference between the wealth of the rich, who own an outsized share of financial assets and other forms of wealth, and that of most people, who struggle to hold on to assets worth more than what they owe. Inflation, when associated with a tight labor market as is usually the case, empowers workers to push for wage increases. Employers are faced with constant demands, exemplified by strikes and quits. By pushing up interest rates, the Fed slows economic growth and job creation, costs workers their jobs, and brings wage gains to a halt. With inflation tamed and rising labor costs beaten back, profit margins are restored, and the owners of capital and the investment class can enrich themselves anew. So, yes, higher interest rates harm the wealthy, but this is a short-run harm. Over the long term, workers are kept in their place by the Fed’s inflation policy that “throws people out of work as a wealth protection device for the top 1%,” as Medlin and Epstein contend.
Growing Doubts About the 2% Inflation Target
Recently, even establishment economists are expressing their doubts about a 2% inflation target. Olivier Blanchard, a senior economist at the budget-balancing Peterson Institute, has pushed for an inflation target of about 3%. So has economist Ken Rogoff, who thinks that the Fed has already in practice adopted a 3% inflation target. Then, in a January 2023 paper, staff economists Randal Verbrugge and Saeed Zaman at the Federal Reserve Bank of Cleveland estimated that a deep recession would be necessary to achieve the Fed’s target of sustained 2% inflation. The recession would cause unemployment rates to rise to 7.4% for two years.
Surely when researchers at the Fed are warning of the disastrous consequences of pursuing its 2% inflation target, it is time to change course and push for policies that would actually help us, in Powell’s words, “achieve a sustained period of labor market conditions that benefit all.”
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