Paul Krugman, in an article titled “None Dare Call It Victory,” calls on the Fed to change its inflation target from two to three percent, which would mean that the Fed could go ahead and reverse course on tightening, since at least one official price inflation measure has reached 2.9 percent.
He gives some reasons for three percent (or, as he casually dropped in, as much as four percent!), like how it would give the Fed more room to lower interest rates in a recession without hitting the zero lower bound, and how price inflation hovered around four percent during the 1980s without much grumbling. I think he’s making this proposal so that if and when a recession comes, he can point back and say that the Fed didn’t follow his advice and raised interest rates too high for too long.
He says that the main impediment to adopting a new target is political—the Fed fears losing credibility since they’ve had two percent as their target for so long. Moving up from that would look like they reneging on the price stability part of their dual mandate.
Of course, any intelligent person could rightfully respond with “Why not?” If all that matters is that inflation expectations are anchored, why not anchor them to three percent instead of two? But if we can say “Why not?” to this idea, then why not six percent? Or seven? Why not any single-digit number? (Double digits are certainly too scary even for Krugman.)
The simple, two-word question exposes the arbitrariness of central bank targets. Economists could conjure up statistics and theory (based on the best Keynesian models) to defend a two percent target just as easily as a four percent target. It’s all arbitrary compared to what would occur in a free market economy with sound money: prices, interest rates, wages, the money supply, and production would all reflect consumer demands as entrepreneurs use economic calculation to arrange production in profitable ways.
In such a context, specific inflation targets would make no sense at all.
