The Absurdity of the 2% Inflation Target

The Federal Reserve has a dual mandate: to create the conditions for stable prices and maximum employment. However, what is considered "stable" in terms of pricing can be rather subjective. You may be surprised to find out that the quasi-sacred 2% inflation target is arbitrary. It wasn't born out of rigorous policy research but rather from a random comment by a central bank governor who, quite frankly, wasn't well-prepared for the role.

In the late 1980s, New Zealand, a country near and dear to my heart (I even named my dog Kiwi), was grappling with substantial price inflation, in the double digits, and sluggish growth, which had caused significant distress among its citizens. For people who'd poured their life savings into government bonds, the impact was devastating. After 20 years of 10% annual inflation, a million New Zealand dollars would only buy what 150,000 could two decades prior. This was hardly helping long-term growth and prosperity.

Enter Donald Brash, a man with zero experience in macroeconomic policy decision-making. Brash studied economics and earned a master’s degree by writing a thesis on how foreign investment damaged a country’s economic development. He then went on to earn his PhD in economics by writing a dissertation that had exactly the opposite conclusion. It was a perfect hedge, since he was almost certain to be right in one of those papers. To that extent, he may have been well-suited for a career as a central banker. Never take blame and never admit a mistake.

Prior to becoming the governor of the Reserve Bank of New Zealand, he worked at the New Zealand Kiwifruit Authority. Not your typical trajectory for someone destined to make waves in global central banking, but nonetheless, he took the helm in 1988. Brash found himself somewhat out of his depth as the central bank governor. When a reporter asked about his inflation target, he stumbled and suggested a range between 0% and 2%. He later confessed that he'd invented the number on the spot, as it simply sounded good.

However, his statement, combined with a sharp drop in inflation, soon saw him hailed as a genius. The fact that the global economy was shifting into a long-term disinflationary cycle was disregarded. Other central bankers quickly adopted the 2% inflation target, which is still the norm today.

Janet Yellen, a former Fed governor, later tried to rationalize this trend. According to her, low inflation rates help 'grease the wheels' during difficult times, enabling employers to avoid cutting wages outright. Instead, they can keep pay steady, allowing inflation to erode the real value of salaries, an approach that helps avoid layoffs that would increase the unemployment rate. For example, an assembly line worker may keep making exactly $20 an hour through a downturn, but in inflation-adjusted terms that pay falls by 2% a year, which could make the factory less likely to resort to layoffs. Yellen suggests that people greatly dislike a decrease in their nominal income, even if the real value of their wages dips. This drives central banks around the world to constantly talk about a 2% inflation target.

Furthermore, Yellen implies that central bankers might prefer to paint a rosier picture of the economy than reality, creating an illusion of strength. Such a strategy can alleviate some pressure from central bankers, thus aiding in securing their cushy positions. When the current Federal Reserve chief, Jerome Powell, or any other central banker speaks about the revered 2% inflation target, remember it's a random figure that was plucked from thin air by someone with no central banking experience. Despite the veneer of authority and the use of complex language, they're as unsure as anyone. After all, if they truly knew what they were doing, we wouldn't see them struggling to handle each new crisis.

Back when interest rates were at zero, Powell confirmed the inevitable: the Fed can't utilize interest rates to stimulate faster growth any longer. His new strategy was to maintain zero interest rates for at least three more years. He hoped that this, combined with increased government spending, would revive the global economy. Despite pumping trillions of dollars into the system, whether the money circulates is out of the central bank’s control – that depends on the government and consumers.

Powell also denied that the Fed's actions were sowing the seeds for any bubble-like conditions in the financial markets. I found that hard to believe, and I wrote about it extensively. The Fed had pumped trillions and trillions of free money into the economy for over a dozen years. Was it really hard to imagine that at some point inflation would rear its ugly head? Did Powell really believe that inflation would be transitory, or was he just hoping it would be so?

Going forward, there are a number of major issues that we need to face. One of the most obvious issues is the record level of debt – personal, corporate, and government. This situation is a natural consequence of years of the Fed's free money and the federal government's massive deficit spending. Much of this corporate borrowing simply conceals poor performance. Moreover, unless much of this debt is retired soon, we will be ill-equipped to deal with the next financial crisis. To think we won't face another financial crisis is naive. It's inherent to capitalism: booms and bubbles are inevitably followed by contractions and crises.

As government deficit spending gets increasingly constrained due to an ever-expanding federal deficit, both in absolute and relative terms, our options become even more limited. Additionally, the Fed’s balance sheet has already exploded from less than $1 trillion to roughly $9 trillion, and even they have some limits. Another major issue is the fact that we have multiple bubbles in major markets. Equities and real estate, in particular, are extremely overvalued and very vulnerable to exogenous shocks.

Even the anticipated benefits of IT can only drive stock prices so far. Am I forecasting an imminent, fierce sell-off in stocks and commercial real estate? Not exactly. I am simply noting that conditions are ripe for some serious problems and some price adjustments over the coming nine to twelve months are quite likely. The stock markets are overheated, and they need a cooling off period.

There's a lingering hope within the Fed that we might, given time, grow our way out of this predicament without a recession and with moderate inflation. Overall, Fed policy has been a classic case of "kicking the can down the road," leaving it to future generations to deal with the problem. If things turn really ugly, a distinct possibility, my genuine worry is that the authorities, under further duress, might resort to a traditional trick: inflating our way out of trouble.

This isn't a new tactic. After the Treaty of Versailles, Germany chose to pay their astronomical war reparations with devalued marks. That ultimately led to the rise of Hitler. History is full of similar instances of governments and rulers resorting to devaluing their currencies to mask their society’s social and economic problems. It's conceivable that the authorities might decide to tolerate a significantly higher inflation rate. While this approach could help mask the problem temporarily, it's certainly not a viable long-term solution.

In fact, the 2% “solution” is just a subtle form of the boiled frog syndrome. This is where a poor frog is placed in a pot of water, and the temperature of the water is slowly increased. The frog will adjust and not jump out of the water until sadly, the frog boils and dies. If the water had been immediately heated to a high temperature, the frog would have jumped out right away.

In the current example, we aren’t likely to notice a 2% jump in prices each year, and it is only in hindsight that we recognize that over 35 years, half our buying power has been destroyed. Yes,  we are all the frogs in the story, being slowly damaged by a steady, gradual, intentional eroding of our buying power by the authorities.