A higher inflation rate of three to five percent produces better outcomes by lowering the unemployment rate and creating labor market bargaining conditions that help connect wages to productivity growth.
The Federal Reserve has now openly adopted a two percent inflation target, with both Chairman Bernanke and the Federal Open Market Committee publicly committing to holding inflation at that level. Though not a problem today, this two percent target represents a policy trap that will undercut the possibility of future wage increases despite on-going productivity growth. That promises to aggravate existing problems of income inequality and demand shortage.
The Fed’s new policy is tactically and analytically flawed. Tactically, at this time of global economic weakness, the Federal Reserve should be advocating policies that promote rising wages rather than focusing on inflation targets. Analytically, its inflation target is too low and will inflict significant future economic harm.
There is little reason to believe a two percent inflation target is best for the economy. Those economists who claim it is are the same economists who should have been discredited by the financial crisis of 2008 and the economic stagnation that has followed. Their claims are based on the so-called “Great Moderation”, the two decade period of modest inflation and stable growth, which preceded the crisis. However, it is now clear the Great Moderation was the product of a twenty-five year credit bubble, supported by the artifact of persistently lower interest rates that can fall no further.
If, in the future, the Federal Reserve feels it must set inflation targets, there are strong grounds for believing a slightly higher inflation rate of three to five percent produces better outcomes by lowering the unemployment rate and creating labor market bargaining conditions that help connect wages to productivity growth. Over the last thirty years, American workers have faced prolonged wage stagnation despite significant productivity growth. The one exception was the late 1990s and 2000 when the unemployment rate fell to four percent, briefly creating conditions in which workers were able to win wage increases. That history shows the importance of full employment for shared prosperity.
The two percent inflation target represents a cruel trap. The unemployment rate will eventually come down, and when it does the economy will bump against the Federal Reserve’s new self-imposed inflation ceiling. That ceiling likely coincides with an unemployment rate of six percent or higher. Under the new policy regime, the Federal Reserve will then have reason to pull the trigger and raise interest rates, thereby trapping millions in unemployment and ensuring continuation of the second round of wage stagnation which began after the stock market bust of 2001.
The Federal Reserve’s two percent inflation target constitutes a backdoor way of forcing society to live with a “new normal” of permanent wage stagnation and unemployment far in excess of full employment. In effect, by adopting this target, the Fed has surreptitiously abandoned its legislated mandate to also pursue “maximum employment”.
The two percent inflation target would not pass muster if society were to have an open debate about what constitutes maximum employment with stable prices, and whether the economic crisis has created structural change that warrants abandoning previously attained employment goals. However, rather than engaging in democratic policy deliberation befitting an open society, the Federal Reserve has opted for a quiet end run that will make restoring shared prosperity even more difficult.
The political and economic logic of the moment makes it difficult to challenge the Fed. First, inflation is now low so that the public’s ear is not attuned to the threat of the two percent target. Second, compared to most of his cohort of leading economists, Chairman Bernanke has been a force for humane and sensible economic policy, understanding of the misery inflicted by mass unemployment and willing to do something about it. Criticizing him can therefore appear unappreciative. Third, in a period of wage stagnation, opposition to low inflation and support for higher future inflation can sound like support for higher prices. That is a misunderstanding. The opposition is to an inflation target that will permanently elevate unemployment and prevent workers from bargaining a fair share of productivity growth.
Thirty years ago the wages of ordinary people started to stagnate. A big reason for that is working families lost the economic policy battle. This must not be allowed to happen again after the economic crisis of the last several years. Whether intended or not, the Federal Reserve’s two percent inflation target will turn out to be a below the radar policy cruise missile aimed at the heart of shared prosperity. It must be shot down.
(This op-ed was posted on the FT Economists’ Forum on Tuesday July 31, 2012).