Planet Money - Two Indicators: The 2% inflation target

Episode Date: January 13, 2023

If the Fed had a mantra to go along with its mandate, it might well be "two percent." We look into how that became the target inflation rate, why some economists are calling for a change and how the inflation rate becomes unanchored.Subscribe to Planet Money+ in Apple Podcasts or at plus.npr.org/planetmoneyLearn more about sponsor message choices: podcastchoices.com/adchoicesNPR Privacy Policy

This is Planet Money from NPR. I was thinking the other day about my favorite contemporary opera. Wait, you have a favorite contemporary opera? Yeah, and you will too, Waylon, after I play, 6, 1, 2, 3, 4, 5, 6, 7, 8, 1, 2, 3, 4, 5, 6, 7, 8, 1, 2, 3, 4, 5, 6, 7, 8, 1, 2, 3, 4, 5, 6, 7, 8, 1, 2, 3, 4, 5, 6, 7, 8, 1, 2, 3, 4, 5, 6, 7, 8, 1, 2, 3, 4, 5, 6, 7, 8, 1, 2, 3, 4, 5, 6, 7, 8, 1, 2, 3, 4, 5, 6, 7, 8, 1, 2, 3, 4, 5, 6, 7, 8, 1, 2, 3, 4, 5, 6, 7, 8, 1, 2, 3, 4, 5, 6, 7, 8, 1, 2, 3, 4, 5, 6, 7, 8, 1, 2, 3, 4, 5, 6, 7, 8, 1, 2, 3, 4, 5, 6, 7, 8, 1, 2, 3, 4, 5, 6, 7, 8, 1, 2, 3, 4, 5, 6, 7, 8, 1, 2, 3, 4, 5, 6, 7, 8, 1, 2, 3, 4, 5, 6, 7, 8, 1, 2, 3, 4, 5, 6, 7, 8, 1, 2, 3, 4, 5, 6, 7, 8, 1, 2, 3, 4, 5, 6, 7, 8, 1, 2, 3, 4, 5, 6, 7, 1, 2, 3, 4, 5, 6, 7, 8, 1, 2, 3, 4, 5, 6, 7, 8, 1, 2, 3, 4, 5, 6, 7,. We have a 2% inflation goal. We're going to keep our inflation target at 2%. We're going to use our tools to get inflation back to 2%. 2 is definitely the favorite number of the Fed these days. They are going to do anything they can to bring inflation down to a modest 2%. And Powell said 2% over and over again, like Philip Glass. 17 times I counted until I was under its spell. 2%. 2%. 2%. 2%. 2%. 2%. 2%. 2%. 2%. 2%.

Wow, now I have a new favorite opera. Thank you so much. As I was cutting together all the two percents, I kept thinking, why? Why two percent? There are so many other numbers and songs for that matter. Why not bring inflation down to... One is the loneliest number that you'll ever do. Harry Nielsen would have made a great central banker.

Yes, he would have. And I see your lonely 1%, and I suggest something more mystical. How about... Three is a magic number. Yes, it is. It's a magic number. Schoolhouse rock. Nicely done. Oh, thank you so much. There are lots of beautiful round numbers out there.

Why does the Fed love 2%? Hello and welcome to Planet Money. I'm Waylon Wong. And I'm Robert Smith. Inflation in the U.S. is starting to go down. The Fed wants to drive it even lower. But the musical question is, how low should they go? Today on the show, we're bringing you two stories about inflation from our daily podcast, The Indicator. First, while economists are questioning if 2% is the best target, we do the math and perhaps find a better number. Then we continue our musical journey as we head seaside to hear a shanty about inflation expectations.

The Federal Reserve is filled with some of the smartest economists in the world. They are really good at math. So when they say the perfect amount of inflation is 2%, prices going up 2% year over year, it's easy to think that that was the result of long hours at the chalkboard writing equations. But no. The 2% target for inflation came about in a much more random and serendipitous way. We did a whole show on it a few years ago. 2% came from a small nation in the South Pacific, New Zealand. In that show, we interviewed that famous New Zealand central bank economist, Arthur Grimes. They've probably never heard of me, so that's fine. Well, for those of you who don't know, Arthur Grimes was at the New Zealand central bank in the 1980s. And around that time, they were having high inflation, at times well above 10%. And

they're trying to get it back down. Arthur had this idea that was pretty novel at the time. What if we pick a number and declare that as our inflation target? There was no such thing as inflation targeting at the time. It was only after New Zealand had done it that that term was actually invented. Arthur and the other folks at the central bank thought that maybe 1% was a good, steady number for prices to go up every year. But they wanted some wiggle room. So they picked a range of numbers.

And they had a slogan. Zero to two by 92. So their target was between 0% and 2% inflation by 1992. Zero to two by 92. And guess what? It worked. There was a lot of economic pain along the way and unemployment, but the central bank got the inflation down to 2%.

And this is how the idea of a 2% target was born. Canada did it next, then the UK, then Australia, and eventually the United States. It was in fashion. It was in vogue. I'm 2%. Are you 2%? And like all fashion, after a few years, it didn't seem so strange anymore. It seemed like reality. It was also a useful tool for the Federal Reserve. They could say, don't worry, we have a target, 2% inflation. We will do whatever it takes to keep inflation around there. Economist Alison Schrager says that is what she was taught in graduate school.

This is the sort of thing you would believe in grad school, that monetary policy is just about a lot of mind games. Alison Schrager is now a senior fellow at the Manhattan Institute and a columnist at Bloomberg Opinion. And if the Fed says it's going to be 2%, everyone believes it's going to be 2%. They put that in their wage contracts. They put it in all their planned price increases, futures contracts, all these things. And then it is so. It's sort of like a self-fulfilling prophecy.

It seems like a magic trick, but it did work for a while. When the Fed started to target 2%, sure, inflation was sometimes higher, it was sometimes lower, but it stayed roughly around 2%. And then the magic trick stopped working. Over the last couple of years, inflation went up to 6%, 7%, 8%. Target be damned. And getting it back down to 2 percent again is expected to be painful. The Fed is increasing interest rates. There might be a recession. People could lose their jobs. So is it worth going back to a made up number plucked like a ripe kiwi fruit from the South Pacific? Alison Schrager makes

one argument. When inflation is 2%, she says, no one worries about it very much. I think the advantage of two is it is small enough, it does kind of fall into the background. You know, I was thinking it's like if I were to ask for a sip of your beer, like I could take 2% and you wouldn't get upset with me. I glug 8, 10% of your beer and you're like, what the hell, dude?

Like, get your own. Exactly. On the other hand, the world changes. We get smarter. Maybe there's a better number for Jay Powell to repeat over and over again. About a decade ago, the chief economist of the IMF, Olivier Blanchard, made a bold statement.

2%, he said, is too low. We called him up. He is now a senior fellow at the Peterson Institute for International Economics. It's wiggle room. Olivier argued for more than a decade that if the original reason for the 2% target was to give some wiggle room, then 4% would be better, even more wiggle room. It's basically allowing for adjustments with less perceived pain. During a recession, the Fed lowers interest rates to stimulate an economy. But it can't lower the rates past zero. It can't go negative.

During the Great Recession, this turned out to be a huge problem. A lot of people got laid off from jobs and suffered because the Federal Reserve couldn't lower their rates enough. It hit zero. But if the inflation target is slightly higher, the nominal interest rates can be slightly higher during the good times. Then during recessions, it gives the Federal Reserve more room to drive rates lower. More stimulus, more jobs. Olivier Blanchard has adapted his theories recently, and he is now pushing for 3% instead of 4%. He says that having the price go up 3% a year would still be like a tiny sip of the beer, but it would make recessions easier. But he cautions this is all an academic argument right now.

Central banks shouldn't waver during the tough times. When inflation is back down at normal levels, then, and only then, should we talk about officially changing the target. When central banks change something, then the markets always ask themselves, why do they do that? Have they become kind of inflation lovers? Have they lost credibility? And central bank tries to send. So maybe as the economists debate the ideal 2 or 3 or 4 percent inflation, it's more about being firm than it is the actual number. After all, there is music and beauty in repetition. Two percent. Two percent. Two percent. Two percent. Two percent. After our night at the opera, a day at the docks, we're going to head to Davey Jerome's locker to hear some sea shanties about inflation.

And we'll learn why unanchored inflation can really rock the economy's boat. One, two, three, four. Ahoy there! Welcome aboard the good ship Inflation. Here we sail the economy's treacherous seas, but always expect to return to anchor, around two percent. At least, we used to.

For months we've been drifting farther and farther from our usual waters, and a fear it's taken a toll on me crew. Four de Boons just can't buy what it used to. Aye, I had to sell me good lard to pay for my peg. First mate. Aye, Captain. Tell the people what we've been through.

Aye, Captain. Listen up, lads. There once was a price for a can of beans The refried vine cost $1.90. But then inflation came for me and the price of beans it rose. So I went to work and I asked for a raise, the company groaned and said okay. But then it started to reappraise the price of all it sold. Then the inflation rose, it grew the cost of sugar and toast.

One day the price may slow, but we don't expect that so. When inflation was anchored at 2%, the effect on gas and food and rent was not so bad. But oh my friends, that was so long ago. Unanchored expectations driving more inflation. With prices rising higher and higher, higher and higher, higher and higher. Oh, they're first mate. Higher, higher, higher. I'm down.

Higher, higher, higher. Stop! What is it, Captain? Two strangers be climbing over the starboard bow. State your business, scallywags, or be prepared to walk the plank. Yar! Hey, it's okay. I'm Adrian Ma. And I'm Waylon Wong. We host a show called The Indicator from Planet Money.

Indicator! Yeah, that's right. We were just rowing by and heard your macroeconomic sea shanty, and it sounds like you're really worried about expectations of inflation getting out of whack, you know, becoming unanchored. And we bring good news from land and also oranges. The government's consumer price index came out this week and it shows prices for goods and services in December were 6.5% higher than a year ago. But that's the sixth month in a row it's gone down. So that means inflation is actually easing up. So hold on. I brought my phone here with today's episode on it. And in it, we talk with an economist who says inflation expectations are becoming re-anchored. And that is reason for

you and your crew to have hope. So let me just bring it up here and press play. hope. So let me just bring it up here and press play. Economists like Ricardo Kresch are obsessed with knowing what is going on inside people's heads. Specifically, Ricardo wants to know how much people expect the prices of goods and services to rise in the future. What makes inflation so fascinating is that the more people expect inflation, the more they do the actions that leads inflation to be up. Ricardo, by the way, is a professor at the London School of Economics.

If you expect inflation to be higher and you are a consumer, you're expecting prices of things you buy to go up in the future. You're going to want to buy more of them right now. Save less, consume more, demand more now before those prices rise. If you're a worker, you want to ask for a higher wage now so you can afford the things that you want. If you are a firm who's choosing the prices to set for the goods it sells, and it expects the prices of

the inputs it buys to go up, you want to set a higher price today for the things you buy so that you don't make a loss or even better, make a profit. So no matter where you sit in the economy, expecting inflation contributes to inflation. That is why every central bank talks about inflationist rotations all the time, because a big part of the job of controlling actual inflation is to control expected inflation. And controlling expected inflation is often done through something called anchoring. The term comes from, as you can imagine, a sailing analogy. If inflation is the boat flooding around the sea and it has an anchor on the sand, it can flutter about, but it will not move very far away.

The anchor are the expectations. In the U.S., one way the Federal Reserve tries to accomplish this is through messaging, telling the public over and over again that it is super serious about keeping inflation at the relatively low rate of 2% a year. I'm in love with 2% inflation and I don't care who knows it. Scream it from the rooftops. But beyond just talking the talk, the Fed also tries to walk the walk by raising interest rates when the economy is running too hot or lowering them when the economy needs a boost. For most of the past two decades, that has

worked most of the time. Inflation hovered around 2%. Sometimes it went to 3%. Sometimes it went to 1% or lower. But it would always drift back towards 2%. So in surveys when people were asked, how much do you think prices will change, a lot of people expected that to continue. In short, will change, a lot of people expected that to continue. In short, expectations were well anchored. Then came the pandemic. And over the past couple of years, we have seen supply chain snafus, spikes in demand for a lot of products, but not enough supply. Don't forget stimulus checks and the Fed lowering interest rates to basically zero to help prop up the pandemic economy. Right. And it created this underwater vortex that sort of dislodged the anchor that was tying inflation expectations to 2%. And Ricardo says he actually

saw signs of this starting to happen two summers ago in 2021. When you look at those surveys of households, as well as firms, by the way, but let's focus on households here for now, you were starting to see that on average, they were still saying 2%, but you're starting to see a lot of people starting to say three, four, five and higher numbers. And that's why I said, I think that we're really getting into a bad situation. And it turns out that I was right. But at the time, the head of the Federal Reserve, Jerome Powell, and also a lot of others, they were saying that inflation was likely to be, quote, transitory. But as these transitory supply effects abate, inflation is expected to drop back toward a longer run. Basically, here today, gone before you know it. But that, of course,

was not what happened. As a result of policy that should have pivoted earlier, what we had is that inflation shot up and stayed up for a month and another month and another month and another month. And at the same time, also a little bit bad luck, the things that were going up in prices are things that people are very sensitive to, like gas prices. Or grocery prices or rent. And so people's expectations of how much inflation would increase, at least for the next year, became unanchored. And the worry was that if that continued and more and more people believed inflation would just keep getting worse, that could lead to an inflationary spiral. Then, about a year ago, as we all know, the Fed changed its tune.

These problems have been larger and longer lasting than anticipated. It said, OK, we have a problem here. It started a series of interest rate hikes. By one quarter percentage. by a half percentage point. Three quarters of a percentage. Three quarters of a percentage. Three quarters of a percentage. 75 basis points. Going from around zero to now around four and a half percent.

And while there has been some pain, the good news is that the Fed's actions seem to be working to bring down inflation. And in turn, expectations for inflation in the shorter term seem to be re-anchoring. Recent consumer surveys by the New York Fed show people's expectations of future inflation are also starting to tick down. And Ricardo is confident that inflation is heading back to 2%. He says he has no doubt the Fed will stick to that plan. Where, of course, uncertainty remains is whether they'll come down in the space of 12 months, 24 months or 36 months. Of course, all of this is contingent on the Fed convincing everyone that it's committed to bringing down inflation no matter what, even if unemployment goes up and the economy tips into a recession.

So, Captain, what do you think about what Ricardo said? Are you feeling any better? I guess a little inflation's not so bad. Two percent would make us glad. Someday, lads, we won't be sad if expectations hold. Oh, the inflation rose. It grew the cost of sugar and toast. One day the price may slow when inflation's anchor holds.

Yar. Special thanks to Captain Robert Smith, First Mate Peter Buren, and the ad hoc singers of Framingham High School. And to Sarah Gonzalez, Karen Duffin, and Darian Woods, who worked on the show about the history of the 2% back in 2018. This episode was produced by Nikki Ouellette and Jamila Huxtable and engineered by Maggie Luthar. Sarah Juarez checked the facts and Kate Kincannon edited the show. I'm Waylon Wong. This is NPR. Thanks for listening. And a special thanks to our funder, the Alfred P. Sloan Foundation, for helping to support this podcast.