The US Economy Cannot Grow At 2% Inflation

The US Economy Cannot Grow At 2% Inflation

The Fed could have cut short the Great Recession by a year if it had set a 4% inflation target early on, the mark needed for the economy to grow, but raising the target now will likely do little to help the economy.

Boston Fed President Eric Rosengren and Minneapolis Fed President Narayana Kocherlakota recently have floated raising the US central bank’s current 2% inflation target to give it more room to cut rates during economic downturns.

The notion has not gained much traction in part because the Fed does not want to be seen as “fickle” about its commitments, nor admit its mistakes.

In a paper presented at the Fed’s global central banking conference in Jackson Hole this weekend, S. Boragan Aruoba of the University of Maryland and Frank Schorfheide of the University of Pennsylvania showed how setting a 4% inflation target in Y 1984 would have allowed the Fed to cut rates more sharply than it was able to do during the Y’s 2007-2009 financial crisis.

Under that scenario, they said “the return of inflation to average levels is even quicker and recovery of GDP takes about a year less than under the historical policy.”

But, they added that the benefits of raising the target inflation rate depend heavily on the likelihood of a shock pushing the economy to the point where Zero+ interest rates are needed.

That probability, the authors said, is very small: less than 0.1% in the model they used. When they ran simulations of the economic response to raising the inflation target in early Y 2014, they found very little benefit.

 

“While the change in the target inflation rate affects interest rate and inflation dynamics, the path of GDP is largely unaffected,” the researchers wrote.

“Thus, this analysis suggests that if the central bank raises the inflation target now, even if it is able to communicate and convince the public about the credibility of this new policy, there does not seem to be much real effects of this policy change to make it desirable.”

Messrs Aruoba and Schorfheide are known for their research on monetary policy when interest rates are at or near Zero, and their models for tracking business cycles and GDP growth are published by the Philadelphia Fed.

Have a terrific week.

HeffX-LTN

Paul Ebeling

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