Fed’s 2% inflation target based on ‘nothing special’, says BofA

The Federal Reserve has interest rate increase six times this year in an effort to reduce inflation – currently at 7.7% – to what is considered the ideal level of 2%. But how did central banks decide that 2% is more ideal than some other number?

That is a question that some Fed critics have raised. On Friday, american bank is the latest to weigh in on this, to put it bluntly, “there’s nothing special about 2%.”

The Fed has the company within its 2% inflation target. Some countries with the same goal seem to give more confirmation that 2% is perfect.

However, Bank of America took a different view, saying the Fed might be reluctant to adjust its 2% target to a different number because that would undermine its credibility.

Ethan Harris, Bank of America’s global economist, writes: “Changing the target the first time it’s seriously tested would undermine the credibility of central banks, raising real concerns about the slide”.

The Fed’s 2% target is officially passed in 2012. But the Fed and other central banks used it more informally amid high inflation in the 1970s and 1980s.” The target, BofA said, provided a “buffer” to policymakers by providing an opportunity to cut rates during a recession while eliminating much of the risk of deflation.

Assume that the real neutral policy rate is 2% and core inflation rises to 3% during the boom, writes Harris. “Then, to constrain policy, the central bank will raise the policy rate above 5%. If and when the next recession hits, they should be able to cut rates by more than 5% before hitting zero. By historical standards, that looks like an appropriate buffer.”

There’s still little to suggest that 2% is the “optimal target,” says Harris.

“The evidence is that stable 4% inflation creates very small additional costs compared to 2% stable inflation. Either way, the economy adapts.”

Harris also argued that 2% does not necessarily “satisfy” the view that central banks must maintain price stability, referring to the Fed’s two main goals of maximum employment and maintain.

The BofA said if inflation stabilizes at 3%, the Fed could compromise or give itself more time (though without a clear deadline) to hit the target. BofA said a mild recession could push inflation down to 3%, after which the Fed could reduce inflation to 2% over time – similar to what happened in the 1980s and 1990s.

However, the Fed’s obsession with the 2% target risks pushing the economy into recession, said Barry Sternlicht, CEO of private investment firm Starwood Capital Group, and prominent economist William Spriggs , before told Luck.

“There is no written statement that inflation is supposed to be capped at 2%,” Spriggs said. “That target is not the result of an economic model that assumes 2% inflation is the ideal level of inflation.”

Sternlicht, who has criticized the Fed for using lagging numbers – measured by the consumer price index – that don’t really show what’s going on with inflation in real time, criticized the 2% target.

“I think the 2% figure is pretty arbitrary,” says Sternlicht. “And could it be 3% or 4%? That will be fine.

He added: “I think 2% is an artificial goal that seems like a nice number. But it’s close to zero. And the thing is, when you go up to 2%, you can easily go down to minus 2%. You can enter a deflationary world where there is no demand and there are too many goods.”

Either way, Harris suggested the Fed should wait until inflation is under control to make any changes to the 2% target. At that point, “it’s less of a worry about a lack of credibility or a slippery slope,” he said.

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