Rethinking Price Stability

Central banks are not equipped to tackle the structural forces that underlie the deflationary bias of today’s global economy. The big issues are income inequality in both the developing and emerging economies, excess saving especially in East Asia, persistent trade imbalances, the human cost of rapid technological advances, and climate change . All these factors weigh on growth prospects and have undermined the effectiveness of monetary policy in achieving full employment. In short, ultra-generous monetary policies and negative real interest rates have had limited success in overcoming these structural obstacles to growth, and conversely quantitative tightening has done little to impede growth, contrary to claims by the Trump Administration. Notwithstanding those limitations to policy effectiveness, the Federal Reserve is contemplating whether to change its framework for targeting inflation from a simple guideline of 2% per annum to something more aggressive. Unfortunately, no monetary elixir will fix what ails global growth.

The Origins of the 2% Target

The Federal Reserve’s current policy framework evolved from the Full Employment and Balanced Growth (aka ‘Humphrey-Hawkins’) Act that the US Congress passed in 1978 amidst both rising unemployment and growing inflation. Among other things, the Act mandated the Board of Governors to establish a monetary policy whose goals were to promote full employment and price stability and to sustain long-term growth. In addition to these general goals, the Act set specific targets for unemployment and inflation. Namely, economic policies were supposed to reduce unemployment to 4% for the working-age population and inflation to 0% by 1988. The latter target was inappropriate for several reasons including its proximity to destructive deflation and the tendency of most measures of inflation to have an upward bias, especially those measures using fixed expenditure weights such as the Consumer Price Index.

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