Inflation Target: 3.0% | Seeking Alpha

There is more and more talk these days about the Federal Reserve raising its target rate of inflation from 2.0 percent to 3.0 percent.

Let me just say right off, that in my mind, this was not unexpected. It was just a question of when.

Inflation has been a real battle for the monetary authorities for the past year or so, and there seems to be some feeling that the Federal Reserve and others are beginning to have an impact by lowering inflation rates.

But, the question that more and more people seem to be asking is, as the inflation rate is being brought under control, should the authorities go back to the 2.0 percent level they have sought for so many years?

There seems to be growing support for the target rate to go back to 3.0 percent rather than 2.0 percent.

As Karen Ward writes in the Financial Times,

“Are we heading back to the stubbornly low inflation that prevailed for much of the past two decades?”

“Or, will it stick at a higher level?”

To Ms. Ward,

“In my view, 3.0 percent will be the new 2.0 percent.”

The Problem Of The Past Two Decades

And, what, may we ask, was the problem with the 2.0 percent inflation target?

Well, for most of the past two decades we were stuck with real economic growth of just over 2.0 percent, say about 2.3 percent.

This, many commentators suggested, was too low of a growth rate.

The economy needed to grow faster than this.

But, why was the growth rate of the economy so slow?

Well, my studies show that the economic growth rate was so low because most of the government stimulus money going into the economy went into the financial circuit of the economy and not into the real goods circuit of the economy.

Thus, we had higher asset price inflation than inflation of the prices of real goods and services.

For example, during the past two decades or so, during periods of economic expansion, stock prices went up and up and up. The price of real goods and services went up only modestly.

Investors had found out that putting their money into assets resulted in higher returns with less risk than channeling the funds into real capital expenditures.

Consequently, goods price inflation went up slowly, real economic growth rose slowly, and asset prices went through the ceiling.

Smart investors learned very early where they should be placing their money.

And, since it was the wealthy that found this investment outlet, the income/wealth distribution of the United States became more unbalanced.

Why The Change In Policy

Economic policy changed in the last forty years of the last century.

The “New Economic Policy” of the Kennedy Administration sought to get the economy moving again and sought lower rates of unemployment.

Their “New Economic Policy” became built around something called the Philips Curve, a statistical relationship that showed that the government could achieve lower rates of unemployment in the economy if it could raise the rate of inflation a bit.

The 1963 tax cut was based on this thinking and President Lyndon Johnson was a fervent supporter of this approach.

The approach became acceptable to Republicans as President Richard M. Nixon bought into the program in 1970.

Modest inflation became the focus of both Republicans and Democrats after that.

This economic approach to the economy really stabilized after the turmoil of the inflation of the 1970s and the Volcker-led Federal Reserve put down of inflation in the early 1980s.

Stimulus monies now went more and more into the financial circuit of the economy and went less and less into the real goods circuit. Asset price inflation became the new pace to advance, while goods price inflation became less and less of a concern.

The stock market rose and rose and rose while real economic growth remained at just a very modest level.

People wanted faster economic growth.

Now Is The Time

So, now we have reached a new place in history.

After all the turmoil of the past two years, analysts are looking at what went on over the past two decades, and, unsatisfied with the economic performance of that period in time, are raising their voices in support of an economic program that they believe will give then faster real economic growth.

And, the program they are promoting is taken from the relationships depicted in the Phillips Curve. But, now, to get faster economic growth, the inflation target must be raised.

So, we move the inflation target from 2.0 percent to 3.0 percent.

But, this is just what Milton Friedman, the Nobel prize-winning economist, argued would happen.

Mr. Friedman argued that the Phillips curve had to take into consideration the relationship between the “expected rate of inflation” and the rate of unemployment.

If the rate of inflation remains relatively constant, the “expected rate of inflation” will be the measured rate of inflation. So, if inflation does not change much at all, the Phillips curve remains relatively stable, and what you chart captures the trade-off between inflation and unemployment.

But, if the inflation level changes, changing “expected inflation,” the Philips curve will shift. It will now take more inflation to achieve the same former goal of unemployment.

That seems to be what has happened in the U.S. economy. During the past two decades, as the Federal Reserve worked off of a 2.0 percent inflation target, the rate at which the real economy grew, fell.

Now, analysts are in a position where it has become necessary to raise the target rate of inflation to achieve a faster growth rate for the real economy.

This is exactly what Mr. Friedman projected.

Continuing, the argument goes that if the Fed maintains the 3.0 percent rate of inflation, inflationary expectations will change and result in a slower rate of growth for the economy.

And, the story continues.

In the mind of Mr. Friedman, if the inflation target is raised to 3.0 percent, sometime in the future, the inflation target will have to be raised to 4.0 percent…then 5.0 percent…in order to maintain the higher rate of economic growth.

In Mr. Friedman’s view, the approach, building on the assumptions of the Phillips curve, is not a stable one and, over time, results in higher and higher levels of inflation.

But, once you start with a program guide like that, it becomes very hard to shift your approach. What do you take up next?

Well, don’t be surprised if the Federal Reserve accepts a 3.0 percent inflation target.

But, don’t be surprised if that target is raised again in another three or four years.