The 2% Catastrophe: How One Number Explains the Miserable Economy

The Federal Reserve is crucifying the U.S. economy on a cross of two-percent inflation.


The Federal Reserve balance sheet contains roughly $2.5 trillion worth of Treasuries, Fannie Mae bonds and mortgage-backed securities. But there is one asset the Fed considers invaluable. Credibility.

Most people think the central bank's job is manipulating interest rates, but the Fed is really in the business of making and keeping promises about the economy. Lately the Fed is obsessed with a narrow construction of credibility that is holding back the entire country.

The Fed has fetishized two-percent inflation.


The Fed makes a very simple promise: It promises to keep inflation at a certain level every year. That level has changed over the past 30 years, but it's currently around 2% a year. If the economy is running too hot, the Fed raises interest rates. If it's running cold, it lowers rates.

For 30 years, this worked spectacularly. Recessions were rare and shallow. Inflation was low. Then 2008 happened. Even zero interest rates weren't enough to revive the collapsing economy. That's still mostly true now. In fact, our disappointing recovery is in large part the result of a central bank target that no longer serves the economy.

Let's think about why a two-percent inflation target is a problem now, and what a better target would look like. The below chart compares the economy's long-term growth trend (blue) with the actual size of the economy (red). I've included the numbers going back to 1980 so that you can see that this isn't a case of the housing bubble making us vastly overestimate the economy's productive capacity. You can go back further if you like. The results are the same. The two lines barely deviate from each other -- until now. (The only other exception is the Great Depression).


We have a lot of catching up to do. But a two-percent inflation target -- mostly -- prevents us from getting the catch-up growth we need. Now for the disclaimer. The Fed doesn't have a strict two-percent mandate. The Fed is supposed to pursue full employment too. And as Greg Ip of The Economist has pointed out, Bernanke has said that he is willing to tolerate greater than two-percent inflation if unemployment is still high. But practically, the Fed's two-percent inflation target acts like something fairly close to a ceiling. Indeed, wunderkind blogger Evan Soltas has found that the Fed becomes approximately 17 percent more sensitive to changes in inflation than in output for each percentage point the Federal funds rate falls. The Fed might say that it'll let inflation run a bit higher, but history suggests otherwise. So do its forecasts for inflation over the next few years.

Imagine that the economic recovery actually picks up. Unemployment is still far too high, but it's falling at a rapid clip. And here's the crucial bit: say inflation creeps over 3 percent -- or even hotter. It's hard to believe the Fed wouldn't tighten in this scenario given its inflation bias. Higher interest rates would push down growth and slow the decline in unemployment. In other words, when the economy is in a deep hole, a too-low inflation target puts a speed limit on the recovery.

There are easy enough fixes for this too. A higher inflation target, for one. That's basically the same as raising the speed limit. But we can do better still. To revert to econospeak, a level NGDP target probably makes the most sense. In English, this means that the Fed should target the total size of the economy -- that is, inflation and growth together -- and try to keep it close to its long-term trend. The "level" part of the "level target" means that the Fed should make up for any past mistakes. For instance, if the Fed undershoots its targets for a few years -- basically, the situation we're in now -- then it should try to catch up and get back to trend as quickly as possible. That's not a speed limit. It's a speed minimum.


All of these alternative Fed targets essentially amount to saying Bernanke and Co. should create more inflation today. That raises two questions: 1) Would higher inflation really help us, and 2) If it would help, would it outweigh any costs? Let's consider these in turn.

The case for higher inflation has to do with debt. More inflation now would make new debt more attractive and old debt less onerous. When most people think of inflation, they think about paying more for gas and groceries. How does that make anything better? The answer is that those prices are set in international markets and are mostly beyond the control of the Fed. When we talk about the Fed creating inflation we're talking about wage inflation. 

Higher incomes would make it easier to pay off old debts that don't change. To go back to econospeak one more time, it would speed up the deleveraging process that's been holding back private demand. It would also make taking out new loans a better deal. We can thank our depressed economy for this. In normal times, higher inflation just translates into higher interest rates, so more inflation doesn't make more borrowing make sense. But these aren't normal times. If inflation goes up, interest rates won't. Borrowers would pay a lower real interest rate. 

There's a specter haunting this inflation debate -- the specter of the 1970s. Back then, we got something that most economists at the time didn't think was possible: a combination of high inflation and high unemployment. (Milton Friedman, of course, predicted this would happen back in 1968). Previously, economists had thought there was a fairly clear trade-off between inflation and unemployment called the Phillips Curve -- if you got more of one, you got less of the other. What happened in the 1970s? Oil shocks. Cost-of-living-adjustment contracts were common enough back then that higher oil prices got transmitted to the rest of the economy in a way they don't today. More expensive oil pushed up both unemployment and inflation.

The problems of the 1970s are not our problems. We've had oil shocks in 2008 and 2011 and 2012 that have not set off inflationary booms. There's little reason to expect high inflation to coexist with high unemployment today. And as long as higher inflation is expected, there's little reason to expect there to be much in the way of actual costs. The Fed just has to tell us it wants higher inflation.


If it's so easy, why isn't the Fed doing it?
On Wednesday, Binyamin Appelbaum of The New York Times asked Ben Bernanke if it was worth tolerating slightly higher inflation over the medium-term to bring unemployment down faster. Here's the Fed Chairman's response:

We, the Federal Reserve, have spent 30 years building up credibility for low and stable inflation, which has proved extremely valuable in that we've been able to take strong accommodative actions in the last four, five years to support the economy without leading to an unanchoring of inflation expectations or a destabilization of inflation. To risk that asset for what I think would be quite tentative and perhaps doubtful gains on the real side would be, I think, an unwise thing to do.

This is equal parts misguided and afraid. Let's tackle the misguided part first. Inflation has remained low despite the Fed's unprecedented and unconventional actions the past 4 years not because of its credibility. Inflation has remained low because of the severity of the slump. Massive deflationary forces have battered the world economy since 2008. We wouldn't expect, what were in retrospect, relatively modest asset purchases to radically unmoor inflation expectations in this context.

There's a broader critique. The Fed is acting as though it gets credibility from its target itself, rather than from hitting its target. The Fed won't lose credibility if it changes its target. The Fed will lose credibility if it misses its target -- if it gets more (or less) inflation than it wants. If the Fed says it wants four-percent inflation and gets it, that's no less "credible" than if it says it wants two-percent inflation and gets it.

I'm afraid to say something else might be going on here. The Fed might be worried that it can't get four-percent inflation if it says it wants it. This is almost certainly not the case, but the thing about unconventional strategies is that they are inherently uncertain. And that uncertainty seems to be tilting the FOMC towards inaction. The logic is that it's not better to have tried for four-percent inflation and lost than not to have tried for four-percent inflation at all. The former risks losing credibility, while the latter doesn't -- albeit at the cost of an economy running well below capacity. It's what a certain Princeton professor called a case of "self-induced paralysis" when he excoriated the Bank of Japan for a similar mindset a decade ago. Of course, that professor was none other than Ben Bernanke, which gives this all a tint of Greek tragedy.


Let's try a quick thought experiment. Imagine that you and a friend -- let's call him Ben -- meet up every Sunday at 2pm to workout. But then something comes up. Ben tells you that he has
to leave early the next few weeks -- unless you want to meet at 4pm instead. The obvious solution is get together later. You trust that Ben will show up at 4pm, because he's showed up at 2pm all this time.

It's the same with inflation targeting.

This probably sounds facile. It is. But that's only because the answers to our problems are facile. There's no reason to think prices will spiral out of control if the Fed targets four-percent inflation, because the Fed is credible. And it's not as if the Fed doesn't have experience targeting higher inflation. It did it in the 1980s, when it targeted ... four-percent inflation. That wasn't some inflationary nightmare. That was "Morning in America."

I don't doubt that Bernanke wants to do more. I just wish he'd ditch his soft-spoken, professorial demeanor. Get mean. Maybe practice in the mirror. (YOU WANT THE TRUTH? YOU CAN'T HANDLE THE TRUTH ABOUT HOW MUCH INFLATION WE NEED). Whatever it takes to get him to drag the rest of the FOMC to do more. We promise we won't think you're less credible if you put people back to work. Just the opposite.