Paul Volcker takes issue with the Federal Reserve’s two-percent inflation target. He wonders why Fed officials have become so focused at a level of decimal precision on a target that cannot be hit so precisely. It is an old point, but one worth making.
The issue with inflation targeting is not merely one of precision, however. Just as important is how such a target is interpreted for policy making. Is it a symmetric target, in which case the Fed will try its best to achieve two-percent inflation each period? Is it contingent on past performance, in which case the Fed might try to make up for over- or under-shooting its target and thereby achieve two-percent inflation on average? Or, is it not really a target at all, but rather a ceiling—an upper bound on the rate of inflation that the Fed deems acceptable?
And what is so special about two percent, anyway? Volcker suggests it is little more than a historical accident that two percent inflation has come to be sacrosanct. He points to the success of New Zealand, following a long period of high inflation and slow economic growth, as establishing the precedent:
The new government set an annual inflation rate of zero to 2 percent as the central bank’s key objective. The simplicity of the target was seen as part of its appeal—no excuses, no hedging about, one policy, one instrument. Within a year or so the inflation rate fell to about 2 percent.
In other words, targeting two percent is the result of practical experience, not sound theory or robust empirical support.
There is nothing magical about two percent inflation. And, to the extent that our modern inflation-targeting regime is based on the experience of New Zealand, two percent should be thought of as more of an upper bound than symmetric target. That inflation has come in a little under two percent does not imply that the Fed can improve matters by producing a little more inflation. But the conversation that has followed suggests the Fed could do a better job communicating its objective.