Friday, December 19, 2014

Inflation below but close to 2%

A most interesting article on how we ended up with the 'below, but close to 2%' target for inflation! Beyond this 'historical interest' the article is useful for IB HL and SL Economics candidates because it explains the problems a 1% target would entail and why the 2% target may have been a bit too low (and, perhaps, a 3% or 4% target better).  Janet Yellen's position is most interesting as well as Blanchard's of the IMF and Alan Blinder's of Princeton.

Ms. Yellen, who now runs the institution, worried that announcing an inflation target would make the Fed focus only on inflation and neglect its responsibilities to bolster growth and jobs. She worried that zero inflation could paralyze the economy, particularly during slumps, and felt that some inflation was necessary.
“To my mind the most important argument for some low inflation rate is the ‘greasing the wheels argument,’” Ms. Yellen said in a closed door meeting of Fed policy makers in July 1996. When businesses run into rough times, they may be inclined to cut workers’ pay. But in practice, that doesn’t happen much. Even in a severe downturn, businesses are more likely to cut hours, conduct layoffs or keep positions vacant than cut pay. That’s one reason recessions tend to lead to higher unemployment instead of lower wages.
Inflation helps deal with this problem. When there is a bit of inflation, employers can hold workers’ pay steady during a downturn yet have it decline in inflation adjusted terms. Inflation creates an adjustment mechanism: An assembly line worker may keep making exactly $20 an hour through a downturn, but in inflation adjusted terms that pay falls by 2 percent a year, which could make the factory less likely to resort to layoffs. 
In that 1996 debate, another argument that Ms. Yellen raised against a zero percent target was particularly prescient. The higher the level of inflation, the more that central banks can stimulate the economy during a downturn. Imagine that there is a severe recession and the Fed cuts interest rates to zero, so that when you put money in the bank you get no return. If there is no inflation, your money will retain its purchasing power and be worth the same when you withdraw it. But if there is inflation, the value of your money sitting in the bank becomes steadily less valuable, meaning that you have more incentive to spend or invest it. “A little inflation permits real interest rates to become negative on the rare occasions when required to counter a recession,” Ms. Yellen said in 1996. “This could be important.”

Interesting stuff... here's the link: Of Kiwis and Currencies: How a 2% Inflation Target Became Global Economic Gospel (NYT)

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