What would happen if the Fed raised its inflation target?

Jeff Cockrell | Jul 13, 2017

Sections Public Policy

Collections Monetary Policy IGM Poll

The United States’ economy continues to send mixed signals about how fully it has recovered from the 2007–10 financial crisis. Productivity growth is slow, but consumer confidence is high; unemployment is low, but so is labor-force participation. The tepid recovery invites questions not only about how policymakers and central bankers approached dealing with that crisis, but also how they should approach preparing for or preventing the next one.

Among these questions is, what is the appropriate rate of inflation? The Federal Reserve targets an inflation rate of 2 percent, in part to stave off deflation in the event of an economic downturn. Maintaining a healthy level of inflation could also give the central bank additional room to lower interest rates when it wants to stimulate the economy. But inflation in the US has stayed stubbornly beneath the Fed’s current 2 percent target, and last month a group of economists suggested the central bank consider raising that target. On the other hand, too-high inflation could decrease consumers’ purchasing power and increase their uncertainty about how to plan for the future.

The Initiative on Global Markets polled its Economic Experts Panel on two questions regarding the Fed’s inflation target. Would raising the target from 2 percent to 4 percent change the costs of inflation for households over the long run? Nearly 40 percent of the panel said that it would. A majority of panelists agreed, however, that raising the target would give the Fed the chance to cut interest rates by a greater amount in a future recession.

Michael Greenstone, University of Chicago
“I tend to agree but I think the evidence is more based on intuition and theory than on empirical evidence.”
Response: Uncertain

Austan Goolsbee, Chicago Booth
“If they did this now, costs would be unchanged because they have not even been able to get to 2 [percent], so [it’s] not credible to promise 4.”
Response: Agree

Larry Samuelson, Yale
If the target change leads to higher inflation (otherwise, why raise the target?), then households will bear the attendant costs.
Response: Disagree

Oliver Hart, Harvard
“Nominal rates would be higher and so could be reduced without hitting the zero lower bound. Also real rates would be lower.”
Response: Agree

Kenneth Judd, Stanford
“That is technically true, but I doubt that it would justify a higher interest rate target.”
Response: Agree

Eric Maskin, Harvard
“Higher inflation rates often imply higher nominal interest rates, giving the Fed greater leeway.”
Response: Agree