The origins of the Fed’s 2% inflation target

Make Me Smart June 27, 2023

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Kimberly Adams

Hello, I’m Kimberly Adams. Welcome back to Make Me Smart, where none of us is as smart as all of us. It is June 27.

Kai Ryssdal 

I’m Kai Ryssdal. Thanks for joining us on this Tuesday. If you pay attention to what the Fed is up to, like we do here in this production shop. You know that Jay Powell, the chairman of the Federal Reserve is dead set, dead set on bringing inflation back down to 2%. Which is not where it is right now. And, and so it’s, look why 2% Jay? That’s the fundamental question we’re going to talk about today. Why 2%? Where’d that come from? How hard is it going to be? All that good stuff.

Kimberly Adams 

Yeah. And so to figure out why the Fed decided on the target inflation rate of 2% and whether or not it should stay there, or maybe even go up a notch or down a notch? Who knows. Anyway, here to make a smart about all of this is David Wilcox. He’s an economist at the Peterson Institute for International Economics and director of U.S. economic research at Bloomberg Economics. David, welcome to the show.

David Wilcox 

It’s very good to be with you.

Kimberly Adams

I know we’re supposed to have the whole conversation about this. But surely you can answer quickly. Why 2%? Easy question to get started off.

David Wilcox 

How long is this show supposed to run? Right. So it’s a great question. Then really, let’s start with the basics. The most important point is that central banks set an inflation target and be absolutely clear about its determination to consistently push inflation toward that target and keep inflation low and stable. It’s important about what precisely the target is, but it’s much more important that there be a target and that everybody understand, just like Kai was saying in the intro that the central bank is completely serious about consistently pursuing the inflation target. Central banking actually bears a little bit of resemblance to a good healthy marriage, commitment needs to be at the center of the arrangement. And so it really matters that a central bank, commit to an inflation target, and be completely serious about it and have nobody question its commitment.

Kai Ryssdal 

Why is having that target show important, Mr. Wilcox?

David Wilcox 

Well, it’s important because economies work better when there’s less uncertainty. And uncertainty turns out to be like a needless friction in the system. So if people aren’t clear about what policymakers are trying to do, that leads to all kinds of uncertainties and uncertainties lead to risk premiums. And risk premiums make borrowing more expensive for you and me, when we run a credit card balance or take out a mortgage, it leads to additional expenses for governments when they run deficits. Risk premiums play an important role. But what you don’t want is for a needless risk premium that can be taken out when a central bank is clear about its objectives, clear about its determination to meet those objectives, and communicates clearly about how it’s going to go about doing all of that.

Kimberly Adams

So if the target inflation rate is supposed to promote price stability, given that even 2% inflation, inflation is still prices going up, why is the rate not 0%?

David Wilcox 

Well, there’s a few reasons that push a central bank to adopt a target that’s a little north of zero. First of all, try as they might, the statistical agencies really can’t generate a perfect measure of the rate of increase of the cost of living. Building an accurate measure of inflation is really challenging. But the best estimates are the official measures that we’ve got, overstate the true rate of price increase by a little bit. There’s different measures of inflation. But the one that the Fed sets its navigational guide on, probably is overstated to the tune of something like half a percent per year, according to one recent and highly authoritative estimate. So even if you wanted to target true zero on inflation, you’d aim for something a little north of zero on the actual flesh and blood metrics that we have. A second consideration is, let’s think for just a moment about how the Fed fights recessions. The way it fights recessions mainly, is by cutting its policy rate. And in order to be effective, it needs to be able to cut its policy rate by quite a bit when a recession strikes. If the interest rate is low on the eve of a recession, the Fed is not going to have much cutting room. And so it’s not going to be able to crowd in as much investment as it otherwise would be. It’s not going to be able to cause the dollar to depreciate, it might make our products more attractive in foreign markets. It’s going to be less capable of supporting employment and spending and getting the economy back on track to recovery. So that’s another reason for building in a little bit of a cushion north of zero.

Kai Ryssdal 

Right. So policy rate, we should just be clear is the main interest rate that the Federal Reserve uses in this country. It’s called the federal funds rate. But let me ask you this Mr. Wilcox, why 2%? Did Jay Powell or Ben Bernanke or Paul Volcker or Marriner Eccles, wake up in a fever dream one day and say, 2%? That’s what inflation should be?

David Wilcox 

No. First of all, the only person who calls me Mr. Wilcox is my mother. So I’d be more comfortable with David. Secondly, there was a ton, there was hundreds and hundreds and hundreds of hours of staff research that went into laying the foundation for this. I actually am an alum of the Federal Reserve Board staff. So I engaged in a whole bunch of, I lost some of the good years to that effort. It didn’t hurt by the way that the Fed was not first in line among central banks around the globe to adopt an inflation target. And by the time the Fed got there, in 2012, a number of other central banks had set inflation targets. They differ a little bit from bank to bank, some some of them in terms of their exact dimensions. But 2% was very much in line with, with the global practice among central banks. It was set, by the way you asked who was the chairman at the time, it was Ben Bernanke. This was something that Ben had been working on for a long time, he published a very noted volume, about a decade earlier with three co-authors that laid a lot of the intellectual groundwork for why an inflation target was a good idea. He had done an awful lot of consultation with members of the policymaking committee, the Federal Open Market Committee, some of whom were pretty skeptical when Ben came into office, he did a ton of consultation with members of Congress to make sure that they would be comfortable with this choice, including setting it at 2%. Ultimately, it was a decision of the committee, but that decision was widely vetted before so it didn’t catch anybody by surprise.

Kimberly Adams

There are some economists that think the Fed should raise that target to be higher than 2%, give even more of a cutting cushion, I guess you could say. What do you think of that?

David Wilcox 

It’s a, it’s a good question. What a committee sets, a committee cannot amend. And so I completely agree with the perspective that 2% doesn’t need to be the answer for all time. Let’s think let’s unpack some of the issues around the advisability of amending the 2% target. First of all, in line with the theme that we started out with, which is creating certainty and commitment and comfort and squeezing out risk premiums. You don’t want to be in the business of adjusting the inflation target on a frequent basis or without having really laid a solid foundation, the committee likes to think of its inflation target and the larger elements of the structure around the 2% number as something akin to a central bank’s constitution, it can be amended. But that amendment shouldn’t be undertaken lightly. An inflation target, the designated number is something that needs to endure. For more than this year, it needs to be seen as a solid element of the economic landscape. That said, the world has changed since the 2% number was set in 2012. Back then, the sort of Goldilocks level of the policy interest rate not too hot, not too cold, just right, that Goldilocks level of the policy interest rate was seen as probably in the neighborhood of three and a half or 4%. And that number pretty clearly has come down. In the meantime, the Feds’ best guesstimate today is that that number is more like two and a half rather than three and a half or four. That means just like Kimberly was saying, that means there’s less cutting room for the Fed when times get soft. And so over the longer term in the fullness of time with a solid research foundation laid, I think it could be very beneficial and judicious at the Fed to raise the inflation target from 2%. But right now, job one for the Fed is to restore the credibility of the inflation target and wrestle inflation back to 2%.

Kai Ryssdal 

So put up or shut up, do you think they can do it?

David Wilcox 

Absolutely. No question about it. One of the lessons that every modern central banker has learned coming out of the 1970s was how wrong it was to think that central banks couldn’t control inflation. That was the mistake. That was the fundamental mistake that Arthur Burns made. It was the mistake that was corrected at tremendous cost by Paul Volcker, with a pair of really costly recessions in 1980 and ‘82. There’s no question of the capability of a central bank to deliver low and stable inflation. And by the way, just sort of pro tip here. One

Kai Ryssdal 

Do tell a monetary policy pro tip, you go!

David Wilcox 

What I was just referring to is the reason why Jay Powell pretty conspicuously wraps himself in the mantle of Paul Volcker. Yeah, sometimes that’s quite overt. Sometimes it’s rather subtle. An example of the subtle, subtle approach is when Powell refers to, “we’re going to keep at it.” Well, guess what the title of Booker’s memoir was that right? “Keeping at it.”

Kai Ryssdal 

Oh, that’s so funny. That’s funny. That’s good. I like that. That’s really good.

David Wilcox 

I don’t know for sure that that’s what Jay Powell has in mind. But he is deeply a student of history. He wants to align himself with Volcker. He wants overtly, subtly, in every way in between to make sure that he goes down in history, if need be, as the next generation, Paul Volcker, not as Arthur Burns version 2.0.

Kai Ryssdal 

David Wilcox is an economist at the Peterson Institute for International Economics. He’s also the director of U.S. economic research at Bloomberg Economics. David, thank you so much for your time, and for your expertise and your insights.

Kimberly Adams

That was super interesting.
Kai Ryssdal

I love that, I love that.

David Wilcox 

It’s been fun to be with you.

Kai Ryssdal 

Keeping at it. Oh, man, that’s great.

Kimberly Adams

Pro tips on monetary policy.

Kai Ryssdal 

Only here people on Make Me Smart. Oh, my lordy.

Kimberly Adams

Yeah, you know, it’s, it’s so interesting, you know, to hear him talking about all these lessons learned that the central banks can really control inflation. And all these conversations we’ve had about the struggles of central banks to control inflation as well. But the job is just not easy.

Kai Ryssdal 

No, not at all. Sorry, I’m just Googling here really quickly, because for people who want to know more about what the Fed is doing now and what it has been doing in the past, I highly recommend Jeanna Smialek’s book, and I can’t remember for the life of me what her book is called.

Kimberly Adams

Oh, my god, it’s like downstairs on my shelf.

Kai Ryssdal

No, I know. I know. I know. I know. I know.

Kimberly Adams

Hang on. We’ll have a link to it in the show notes. You’re gonna find it.

Kai Ryssdal 

Yada yada. It’s called “Limitless: The Federal Reserve takes on a New Age of Crisis.” You Yeah, it’s it’s really good, totally readable and Jeanna is great to begin with. So there’s that.

Kimberly Adams

Yes, all those things. Let us know what you think about the 2% target and whether or not it’s a good idea if you have any monetary policy pro tips for us yourself, you could let us know in 508-827-6278, also known as 508-U-B-SMART, or you can email us at makeme smart@marketplace.org And we will be right back.

Kai Ryssdal 

Alright, time for the news. Kimberly Adams you go first.

Kimberly Adams

Big news out of the Supreme Court. But it I don’t know how much of a deal it’s going to be that this happened? Because the bigger concern was, if it didn’t happen, right. So the Supreme Court came out with a ruling this morning on the case was called Moore v. Harper. And it was about this North Carolina redistrict congressional map, redistricting case doesn’t really matter. The big issue was whether or not the independent state legislature theory which we talked about on the show a while back, was going to hold up in the Supreme Court, this idea that since states are supposed to set the rules for their elections, that state courts couldn’t say anything about how state legislatures choose to run elections and draw districts. That was going to have huge implications for every election because it would basically mean that a state legislature comp-composed primarily of one party could draw just districts however they wanted to with no oversight whatsoever, regardless of how it disenfranchised voters. And the court said six to three that that’s like not the deal, that state courts do have the authority to you know, serve as a check, almost a check and balance, you might say, on their own state legislatures. It’s, it’s a huge deal, because this case, had it gone the other way, which a lot of people thought it might because several of the more conservative justices on the court have been on record saying, you know, kind of positive things about this theory and other forums, this would have had just an earth shattering implication for the upcoming presidential election and pretty much every election to come. So there’s a bunch of really nice write ups about it in most of the big publications, I’m looking at one in Politico and the New York Times. But it’s one of these cases that we did talk about a while back, huge deal that it went this way. Surprised some people. And it’s interesting, because North Carolina’s, the people who originally brought the case, the basically the GOP in North Carolina, the state court that originally said I’m going to try to get this right. So basically, they retried the case at the state level, and tried to withdraw it from the Supreme Court by kind of vacating the courts previous decision, with the idea that maybe that would make the court, the Supreme Court, not say anything about it. But so many advocates were so concerned about this theory that the court, they asked the court to make a decision anyway, even though the original case was not effectively before it. And the court did that. And it thought that this was important enough to you know, let it be said that this is what they think about it, and it’s a big deal.

Kai Ryssdal 

Very big, super big deal.

Kimberly Adams 

The other story that I have is just a very quick note. It’s a story I saw last week and just for whatever reason didn’t get a chance to talk about it yet. It’s in GQ, about a surfer who won the biggest surf competition in the world on his breaks from being a lifeguard that day.

Kai Ryssdal

No way that’s great.

Kimberly Adams

Yes, yeah, he was like a local guy who they call casual Luke. He lives on the North Shore in Hawaii in Oahu and surfed, like, the biggest waves in the biggest contest. Like these waves over 40 feet tall, and he won the contest. And GQ has this amazing profile of this guy. And it’s, sure it’s about the competition, but it’s also his life and how his life hasn’t hasn’t changed for him and his family since the competition, and just sort of the struggles of being a local in tourism town where you can’t necessarily afford to live. It’s it’s an economic story. It’s a sports story. It’s a family story, beautifully written, beautifully done, highly recommend. And I just want to throw that in people’s reading lists.

Kai Ryssdal 

That’s great. That’s cool. That’s cool.

Kimberly Adams

All right what’s yours?

Kai Ryssdal

Let’s see. So mine is, I guess it’s, it’s the payoff of a series of cautionary tales. We’ve talked on this podcast before about SPAC’s, the Special Purpose Acquisition Companies and how perilous, they appeared to be to those of us in the outside while those on the inside appeared to be making tons of money. Well, look, most of them companies that went public by SPAC’s, which is a short circuiting of the traditional IPO process, have now gone to zero, that is to say a lot of just are not working out at all, the latest of which is Lordstown Motors, which is really sad because Lordstown was considered a savior when it bought up in 2019, an old GM plant in Northeast Ohio, it was a very, very big deal. They were going to make electric vehicle trucks there and not save that town, but kind of save that town. Right, because there were all kinds of jobs. It was a very, very big deal, lots of coverage, including here. And Tracey Samuelson actually did those stories. And today, Lordstown filed for bankruptcy protection. It’s in it’s in a contract dispute with one of its funders Foxconn, which might sound familiar because it makes Apple iPhones and it also had that big investment in Wisconsin that didn’t work out. But that’s sort of a side story. The main story is an EV maker, which is really capital intensive, but low margin, right, lots of the others as well, Lucid and Rivian are having some challenges. An EV maker has gone bankrupt, because it couldn’t handle the current market conditions for EVs. And then that’s not a good thing. That’s not a good thing. And I just want to point that out.

Kimberly Adams

And I can’t imagine like the folks in that town have been through such a roller coaster, you know, thinking, and I just think to all the people who probably stayed there because they thought it was totally going to be jobs or move there because they thought there was going to be jobs and now their stuck. Totally, 100 percent. Anyway.

Kai Ryssdal 

Alright, so that’s it for news. Let us move on to the mailbag.

Mailbag

Hi Kai and Kimberly. This is Godfrey from San Francisco. Jessie from Charleston, South Carolina. And I have a follow up question. It has me thinking and feeling a lot of things.

Kimberly Adams

Last week, I talked about a man in Texas who invented a machine that can turn air into clean water. And we got this message in response.

Hunter

This is Hunter from Myrtle Beach. I just got done listening to the story about the gentleman in Texas who is creating industrial dehumidifiers to provide drinking water, which is wonderful, super shocked that the two of you, of all people, whiffed on the softball that the guy is basically a moisture farmer, à la Uncle Lars. All right. Thanks for making me smart.

Kimberly Adams

Ahhhhhh. Ahhhhh.

Kai Ryssdal 

Whiffed on the softball Well, thanks.

Kimberly Adams 

Oh man. Uncle Lars. Owen Lars, the uncle who raised Luke Skywalker in Star Wars. Who was, thank you for looking this up folks, a moisture farmer on Tatooine. Which is funny because when I originally saw the story, I wasn’t thinking about that. I was thinking about that scene in Dune where the people go out and they gather do in the mornings to get drinking water. That was sort of what originally came to mind. But yes, of course moisture farmer on Tatooine, much more logical for sure.

Kai Ryssdal 

All right, we also got this.

Kathy

Hey, this is Kathy from Atlanta. I heard Kai and Kimberly talking about the new record for the Rubik’s Cube challenge. I really want them to watch on Netflix The Speed Cubers because there’s a whole relationship behind that record. There’s a long story about guys and autism and speed and passion and it’s really engaging and I don’t even like Rubik’s cube. So they should tune in and really understand more about what happened behind the scenes. Thanks!

Kai Ryssdal 

Excellent, thanks for the recommendation.

Kimberly Adams

Oh I will go and look. That sounds super interesting. Okay. Well before we go, we’re going to leave you with this week’s answer to the Make Me Smart question, which is what is something you thought you knew but later found out you were wrong about? This week’s answer comes from the wonderful folks who made us smarter about rum. While we were in Seattle for our live show, we ended up going to a Rum Bar after the show. Some of us. Here’s Karen McConnell self-described rum nerd and manager at Rumba and Inside Passage cocktail bars.

Karen McConnell

Something I thought I knew that I later found out that I was wrong about is that all rum is sweet. Dosage, commonly seen in cognac production, is a century old practice of adding sugar to your end rum to round out your flavors. The first rums dating back to the early 1700s were described as hot, hellish, terrible liquor, and could have probably used all the help they could get, and well, that meant dosing them with sugar. But nowadays, it’s more of a stylistic choice in the rum world. While, yes, all rum is made from sugarcane … It really is the most diverse spirit in the world and really can run the gamut on flavor from sweet to funky, rich to earthy… grassy to leathery. A lot of this will depend on the island or country of origin in their distillation practices. The sweetness isn’t for you? I bet you there’s a bottle out there that will make you rethink how you think about rum.

Kimberly Adams

I totally thought all rum, was by default, sweet.

Kai Ryssdal 

Yeah. Wow. Learn something new every day on this podcast people, that’s all I’m saying.

Kimberly Adams

Indeed we do. We want to hear your answer to the make me smart question. Our number is again 508-827-6278 also known as 508-U-B-SMART.

Kai Ryssdal 

Today’s episode of Make Me Smart was produced by Courtney Bergsieker. Ellen Rolfes writes our newsletter. Today’s program was engineered by Jayk Cherry with mixing by Mingxin Qiguan. Our intern is Niloufar Shahbandi.

Kimberly Adams

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