The Curious And Elusive Case Of Targeted 2% Inflation (And A Consideration For Fixing It)

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Summary

Federal Reserve targets 2% inflation, yet can't reach it.

The case for targeted 2% inflation being DEFLATIONARY in the medium to long term.

One solution may be to target 0% inflation for an extended period of time.

The Federal Reserve has a dual-mandate to achieve full employment and price stability and have done their part to restore half of this. Employment has been improving, yet still has a long way to go given the labor force participation rate, high percentage of part time jobs, and sluggish wage growth. It is undeniable that the Federal Reserve as well as other central banks around the world are unable to create sustainable 2% inflation with current policy.

As to why this may be, let's start by defining the term. Inflation is the broad and rising cost of goods and services so that businesses can find it profitable to grow and expand and small consistent inflation beneficially avoids the debt-deflation trap. There are two ways that inflation can be created. Either the money supply is increased and there is more money chasing fewer goods, or there is growing demand for too few goods and services via demographic booms, rising incomes, or increasing standards of living.

Inflation targeting of 2% has not been around as long as most people believe. It was toyed with during the Bretton-Woods era (1944-1971), but was adopted by the Bank of England in 1998 at 2.5% and was changed to 2% in 2003. The European Central Bank adopted the policy in January of 1999 at the creation of the Euro and confirmed it in 2003. The United States formally added 2% as a mandate in 2012, but has been informally pursuing it for 15 years or so.

So what gives? Why are central banks all around the world failing miserably at getting to 2% maintained inflation yet were able to create mostly full employment? The answer may be that the target itself is creating a subtle deflationary outcome.

Let's examine the works of Richard Cantillon, a French economist in the early 1700's. Cantillon observed by watching prices of goods after newly minted silver was gained by an empire that market participants who receive newly created money benefit from a higher standard of living before inflation is passed down to later recipients of the new money. This concept of relative inflation and price increases that transfer through the market is known as the Cantillon Effect. This means that the consistent flow of new money at the rate of 2% inflation either has yet to be passed through the economy and is on its way in an incredibly slow fashion (15 years), or that when the 2% maintained inflation reaches its final destination within the economy, there is less than zero net benefit, specifically on demand for new goods via higher standards of living.

Put another way, when inflation reaches a large segment of the population, they see higher costs in necessary goods as well as all unnecessary goods in a delayed fashion.

Now if we carry this postulation to conclusion and convert to basics of supply and demand mechanics, a large segment of the population is seeing a rising cost of necessities (goods that they most certainly will buy) and rising costs of goods that they do not need and will no longer buy. Let us conclude that there is no net demand on excess resources in this instance because demand for goods and services in excess of necessity is shrinking rather than growing.

If this is correct, then what we are seeing is less aggregate demand for resources on net over time. Our clues for this are falling commodity prices, falling sales in retailers, and sluggish yet mostly stable growth.

If these are correct observations, what can be done?

The Federal Reserve recently hiked rates in December and is signaling they may be hiked again since the economy is improving. Instead of signaling for rate hikes, perhaps the FOMC should state that it will instead target 0% inflation for the medium term, which would be a tightening of conditions, but allow excess demand for goods in the unnecessary category to recover, thus boost demand for excess resources and finally increase aggregate inflation. This would modestly avoid the debt-deflation trap and potentially lead to their 2% inflation target over the longer term.

This is slightly different from simply hiking rates because instead of setting expectations for interest rates, the FOMC will set expectations for inflation and allow the market to price interest rates towards the new objective. This would be a way to take the training wheels off the bicycle and serve as a normalization in many senses as well as gauge where natural interest rates should be. The Federal Reserve has helped the economy recover better than practically all others around the globe and deserves credit for this. It will take a lot of thinking to determine the best path from here.

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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.