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Central Banks Should Forget About 2% Inflation

Summary:
Despite years of monetary stimulus, inflation in the United States, Japan, and the eurozone continues to undershoot central banks’ 2% target. Rather than doubling down on their oft-missed goal, however, perhaps the Fed and other central banks should quietly stop pursuing it aggressively. CAMBRIDGE – The United States Federal Reserve has some reasons to cut interest rates at its July 31 meeting, or subsequently if the US economy weakens. (There is also a case for holding rates steady, if growth remains as strong as it has been over the past year.) But one argument for easing is less persuasive: a perceived imperative to get US inflation up to or above 2%. Is Politics Getting to the

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Despite years of monetary stimulus, inflation in the United States, Japan, and the eurozone continues to undershoot central banks’ 2% target. Rather than doubling down on their oft-missed goal, however, perhaps the Fed and other central banks should quietly stop pursuing it aggressively.

CAMBRIDGE – The United States Federal Reserve has some reasons to cut interest rates at its July 31 meeting, or subsequently if the US economy weakens. (There is also a case for holding rates steady, if growth remains as strong as it has been over the past year.) But one argument for easing is less persuasive: a perceived imperative to get US inflation up to or above 2%.

The Fed set the 2% inflation target in January 2012 under former Chair Ben Bernanke, after some other central banks had already done so. Japan followed suit a year later, shortly after Prime Minister Shinzo Abe returned to power on the promise that monetary policy would raise inflation (Japan had previously suffered from falling prices).

The logic was impeccable. With unemployment still high and growth still low in the aftermath of the 2008 global financial crisis, further stimulus was needed. But central banks had already lowered nominal interest rates to zero and could not cut them much further. Monetary policymakers therefore tried to stimulate economic activity by raising expected inflation.

An increase in the expected inflation rate would lower the real interest rate (the nominal interest rate minus expected inflation). And by making it cheaper to borrow in real terms, central banks hoped to persuade households and firms to purchase more cars, buildings, and equipment.

Monetary authorities took several steps to boost inflationary expectations among the public. They emphasized their 2%-or-higher inflation objective; were sincere in doing so; and kept their foot...

Jeffrey Frankel
Jeffrey Frankel, a professor at Harvard University's Kennedy School of Government, previously served as a member of President Bill Clinton’s Council of Economic Advisers. He directs the Program in International Finance and Macroeconomics at the US National Bureau of Economic Research, where he is a member of the Business Cycle Dating Committee, the official US arbiter of recession and recovery.

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