Interestingly, despite the 2% inflation target, The Fed is actually directed by Congress to seek full employment and then zero inflation according to a law passed by Congress in 1978 (see Public Law 95-523 aka Humphrey–Hawkins Full Employment Act) but no one seems to care nor acknowledge the legally mandated zero percent inflation target anymore.
“Upon achievement of the 3 per centum goal specified in sub-section (b) (2), each succeeding Economic Report shall have the goal of achieving by 1988 a rate of inflation of zero per centum (source: https://www.govtrack.us/congress/bills/95/hr50/text)
The 2% threshold is the brainchild of Alan Greenspan back in the 1990s. In his estimation, 2% is the level of inflation below which inflation ceased to be a significant factor in consumer purchase decisions. The thrust of Fed policy on his watch was to keep inflation below that level.
In the 2000s, that threshold became a central bank holy grail, so that making sure inflation was at least that much was seen as a primary means of keeping an economy growing.
2% inflation is the target because, at this point, it's always been the target. There's no underlying economic logic to it.
Thanks again. How does inflation help an economy grow? Logic would seem to dictate that deflation would help the members of that economy flourish, yet it’s never even talked about, like there’s some law of economics that prevents it from being an option.
Milton Friedman's example of how inflation is a monetary phenomenon provides some insight.
As a general rule, people will strive to hold a certain amount of their regular wages. If the money supply is expanded, they will find themselves with an "excess" amount of money, which they do not want to hold, consequently they spend it--thus the expanded money supply gives the appearance of an increase in demand (more spending).
With everyone trying to reduce their "excess" holdings of money by spending, all that can happen is the money just moves around. The only way to resolve this is for prices to rise until prices (and, presumably, wages) are such that the enlarged amount of money people find themselves holding due to an expanded money supply represents their desired amount of regular wages.
Deflation, of course, drives everything in reverse. Thus, whereas inflation appears to create an increase in demand, deflation is going to cause a seeming decrease in demand--people will stop spending and stop moving money around, until prices fall back to the previously defined equilibrium point where the money people hold is their desired proportion of regular wages.
Outside of money supply expansion, increased demand means economic growth. People are producing more, or are at least more productive, thus the economy is either moving outward towards its production possibilities frontier or is expanding said production possibilities frontier. Decreased demand therefore represents economic contraction, and a moving inward away from the production possibilities frontier.
The conceit of central bankers is that a little extra money printed out of nothing will goose demand, and thus stimulate the overall economy. However, the flaw in this thinking is that demand in terms of actual economic output isn't increasing, just the monetary measurement of existing demand is. At higher levels of inflation, the increased price levels actually result in a DECREASE in physical consumption--people are paying more but buying less. I explored this phenomenon and its impacts on the economy when discussing last year's "retail recession".
The problem with deflation is that, at higher levels, it does not result in an increase in consumption: people will only want so many steak dinners, so many flat screen TVs, so many cars, houses, et cetera. Outside of a relatively narrow window decreased prices do not result in increased consumption, whereas increased prices do result in decreased consumption. Moreover, if the money supply is being reduced, money itself is becoming more valuable--and so people will tend to hold more of it.
It was Greenspan's belief--which became canon among central bank economists--that inflation below 2%, by inspiring transitory increases in consumption, could stimulate overall economic output and thus be a spur to economic growth. While the historical data does at least not discredit this thinking, after the 2008 Great Financial Crisis there was a pronounced shift in money supply growth, where the money supply increases no longer roughly corresponded to increases in the consumer price index.
It was in this same era that central bank thinking shifted from 2% inflation being a ceiling threshold (we don't want any more than 2% inflation) to being a floor threshold (we want at least 2% inflation), thus leading to the lunacies of Abenomics in Japan, Quantitative Easing in the US, and Jay Powell's ginormous money supply expansion post-pandemic.
The question of the day is whether the current consumer price inflation we have been seeing means that historical correlations between money supply and price levels are reasserting themselves. If they are, the global economy is facing the mother of all economic corrections.
Here’s a dumb question. Why is 2% inflation a goal? What necessities of the fed or markets does inflation serve?
Interestingly, despite the 2% inflation target, The Fed is actually directed by Congress to seek full employment and then zero inflation according to a law passed by Congress in 1978 (see Public Law 95-523 aka Humphrey–Hawkins Full Employment Act) but no one seems to care nor acknowledge the legally mandated zero percent inflation target anymore.
“Upon achievement of the 3 per centum goal specified in sub-section (b) (2), each succeeding Economic Report shall have the goal of achieving by 1988 a rate of inflation of zero per centum (source: https://www.govtrack.us/congress/bills/95/hr50/text)
The 2% threshold is the brainchild of Alan Greenspan back in the 1990s. In his estimation, 2% is the level of inflation below which inflation ceased to be a significant factor in consumer purchase decisions. The thrust of Fed policy on his watch was to keep inflation below that level.
In the 2000s, that threshold became a central bank holy grail, so that making sure inflation was at least that much was seen as a primary means of keeping an economy growing.
2% inflation is the target because, at this point, it's always been the target. There's no underlying economic logic to it.
Thanks again. How does inflation help an economy grow? Logic would seem to dictate that deflation would help the members of that economy flourish, yet it’s never even talked about, like there’s some law of economics that prevents it from being an option.
Milton Friedman's example of how inflation is a monetary phenomenon provides some insight.
As a general rule, people will strive to hold a certain amount of their regular wages. If the money supply is expanded, they will find themselves with an "excess" amount of money, which they do not want to hold, consequently they spend it--thus the expanded money supply gives the appearance of an increase in demand (more spending).
With everyone trying to reduce their "excess" holdings of money by spending, all that can happen is the money just moves around. The only way to resolve this is for prices to rise until prices (and, presumably, wages) are such that the enlarged amount of money people find themselves holding due to an expanded money supply represents their desired amount of regular wages.
Deflation, of course, drives everything in reverse. Thus, whereas inflation appears to create an increase in demand, deflation is going to cause a seeming decrease in demand--people will stop spending and stop moving money around, until prices fall back to the previously defined equilibrium point where the money people hold is their desired proportion of regular wages.
Outside of money supply expansion, increased demand means economic growth. People are producing more, or are at least more productive, thus the economy is either moving outward towards its production possibilities frontier or is expanding said production possibilities frontier. Decreased demand therefore represents economic contraction, and a moving inward away from the production possibilities frontier.
The conceit of central bankers is that a little extra money printed out of nothing will goose demand, and thus stimulate the overall economy. However, the flaw in this thinking is that demand in terms of actual economic output isn't increasing, just the monetary measurement of existing demand is. At higher levels of inflation, the increased price levels actually result in a DECREASE in physical consumption--people are paying more but buying less. I explored this phenomenon and its impacts on the economy when discussing last year's "retail recession".
https://newsletter.allfactsmatter.us/p/the-retail-recession-a-demonstration
The problem with deflation is that, at higher levels, it does not result in an increase in consumption: people will only want so many steak dinners, so many flat screen TVs, so many cars, houses, et cetera. Outside of a relatively narrow window decreased prices do not result in increased consumption, whereas increased prices do result in decreased consumption. Moreover, if the money supply is being reduced, money itself is becoming more valuable--and so people will tend to hold more of it.
It was Greenspan's belief--which became canon among central bank economists--that inflation below 2%, by inspiring transitory increases in consumption, could stimulate overall economic output and thus be a spur to economic growth. While the historical data does at least not discredit this thinking, after the 2008 Great Financial Crisis there was a pronounced shift in money supply growth, where the money supply increases no longer roughly corresponded to increases in the consumer price index.
https://newsletter.allfactsmatter.us/p/modern-monetary-insanity-part-1
It was in this same era that central bank thinking shifted from 2% inflation being a ceiling threshold (we don't want any more than 2% inflation) to being a floor threshold (we want at least 2% inflation), thus leading to the lunacies of Abenomics in Japan, Quantitative Easing in the US, and Jay Powell's ginormous money supply expansion post-pandemic.
The question of the day is whether the current consumer price inflation we have been seeing means that historical correlations between money supply and price levels are reasserting themselves. If they are, the global economy is facing the mother of all economic corrections.