A Challenge To 'Data Dependent' Fed: Empirically Support 2.0% Inflation Target Or Eliminate It

by: Matt Carpenter

Summary

We are unaware of any body of research to support the Fed's 2.0% inflation target.

Deviations of tenths are used to justify extraordinary policy. 1.3% core PCE/2.1% core CPI supports a near-zero rate, a $4 trillion balance sheet, and consideration of negative rates.

QE, ZIRP and, prospectively, NIRP pose great potential risks and costs. They should not be undertaken in support of an unsubstantiated goal.

An arbitrary inflation target and opaque decision-making process threaten Fed 'credibility'.

If the Fed cannot support costly policies with thorough empirical analysis, it should modify or end them.

In recent posts and comments on Seeking Alpha, we have sought to find a body of research supporting the Fed's 2% inflation target. Nothing convincing has emerged, either from these queries or in our own investigation. Though we may still be proven wrong, it appears that such a body of research does not exist. We believe that the potential costs and risks of past, current and prospective extraordinary monetary policy make it imperative that the Fed provide thorough analysis supporting the inflation objective of such policies:

  1. Why is the rate 2.0% (as opposed to, for example, 1.5%, 2.5%, a band from 1%-3%, or a number that adjusts dynamically as the economy changes)?
  2. Why is the appropriate index the PCE, rather than the CPI, Trimmed Mean or another measure?
  3. What is the sensitivity of other important economic measures (e.g. GDP, jobs) to deviations from the 2.0% target?
  4. Are the policy measures taken to attain the 2.0% target justified by the benefits relative to the potential risks and costs - i.e., Fed policies should be subject to cost/benefit analysis.

The 2% inflation policy is the basis for policy measures of the three largest central banks in developed countries: the Fed, the ECB and the BOJ. Central banks have asserted that achieving the 2.0% target is vital enough to undertake previously unheard of policy measures, including ZIRP, QE, and now the highly controversial NIRP. While the cost of these policies has yet to be fully understood, they have stripped retirees of savings, warped capital allocation, and may produce asset bubbles, if they have not already done so.

The Fed's employment mandate has, by its own admission, largely been met; its current near-zero rate and four trillion dollar balance sheet - crisis measures - are currently being justified on the basis of low inflation. US core inflation now stands at about 1.3% based on the PCE and 2.1% on the CPI. These numbers are steady, and perhaps even set to rise: recently, we have seen wage growth and upward movement in core CPI (headline numbers are lower, due to energy, but energy prices are likely a net benefit to consumers, and the Fed has always looked primarily at core numbers).

To many observers, from economists to consumers, these levels appear healthy, and certainly do not warrant the application of draconian policy measures. If there is no significant benefit to 2.0% inflation over 1.5%, or to the PCE over the CPI, we are imposing significant costs and risks for no reason. If there is a reason the public deserves to understand it, and to weigh whether, among other things, it is significant enough to justify robbing a generation of any meaningful return on safe investments.

While the Fed has asserted time and again that its approach to policy is 'data dependent', there is little transparency on how it translates data into policy; moreover, its policy target of 2% stands largely unsubstantiated. What's the benefit of being 'data-dependent' if the data passes through a black box before it becomes policy, and when the very goal of the policy may well be arbitrary or even counterproductive?

If the Fed refuses to adopt any sort of formula or rule that shows the public how changes in the economy affect its policy, and can't empirically support its policy target of exactly 2.0% on core PCE, it should simply end the charade and admit that it sets policy based on the subjective considerations of its chairperson and voting members. We wonder what impact such an admission would have on the Fed's 'credibility'.

The current policies of the Fed, and other central banks, appear to be based on doing 'whatever it takes' to move inflation towards an arbitrary target, even if the deviation is only a few tenths of a percentage point, and even if these policies impose great costs to the public and great risks to the economy. The Fed has a large staff of trained economists. It is time to use them to provide supporting evidence for key elements of its policy. If it cannot do so, it should expeditiously move to modify or eliminate policies that are costly, risky and unjustified.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.