The Fed has held a 2% inflation target for years, both before and during this episode of high inflation. If it wants to be predictable, it needs to keep a 2% inflation target. Changing the goalposts now would signal the market that the Fed can change what they're trying to do at any time - that the market should not trust the Fed to follow through on what they say they will do.
This part about communication and credibility affecting inflation expectations is true. It's a separate question though, whether the Fed selected the right goalpost in the first place. If they selected the wrong goalposts, it could have dysfunctional implications for the economy.
2% could be worse than 3% in the sense that such a low-inflation economy could be inherently bubble-prone. A very low discount rate inflates the real present value of very distant and hence very speculative cash flows. Inflation is a cost applied to future cash flows just like an interest expense, because cash flows received or paid in the future will purchase less than cash flows received or paid now.
Thus we see landlords buying properties that fail the 1% rule, and are in fact heavily cash-flow negative right now, because the Fed is considered credible and so investors are not heavily discounting cash flows expected to arrive five or ten years from now. Thus we see investors piling into things like crypto and gold, which offer no cashflows, because
inflation expectations are so low it is cheap to play greater-fool-theory games. Thus the S&P500 has a
current earnings yield of only 3.7%.
The Fed might finally have the tools to hold inflation around 2% with relative consistency, but they may have merely replaced the business cycle with the bubble cycle.
Eventually, the recessions come from asset price bubbles instead of from inflationary shocks or too-tight monetary policy. The multi-year asset bubbles ending in 2000 and 2008 were perhaps early examples that will become a trend. Those episodes predated officially communicated inflation targeting, but reflected investors overpaying for distant cash flows in speculative manias for dot com stocks and housing/mortgages. I think it takes a deep confidence in the Fed to make such investments, but in the end the Fed's mandate does not include the deflation of asset bubbles. So the Fed is not empowered to pop bubbles.
The 2016-2018 series of
rate hikes were perhaps an experiment to see if this trap could be avoided, targeting what was at the time perceived to be risky valuations for housing and stocks. I watched in awe as the Fed's dual mandate and inflation target were set aside for the sake of the "normalization" buzzword and arbitrary concepts of a neutral policy rate that were not tied to contemporary measurements. The first hike, in January 2016, came in a month when CPI was 1.24% and PCE was 0.2%, and they had both been low for years. It made no sense in traditional economic terms to hike rates as if we had an inflation problem. Why then, did the FOMC do it?
I think Fed officials circa 2016 were afraid policy was leading us into another bubble economy, and thought the best way to maximize employment - given that inflation was not an issue at the time and given that they weren't going to raise the inflation target - was to prevent bubbles from forming in the first place. As Janet Yellen noted in an
October 2016 speech, recovery from the GFC was slower than models anticipated, possibly because households were increasing their savings to make up for negative home equity and possibly because supply-side destruction during the GFC had simultaneously reduced the economy's potential (i.e. Closed businesses and their contribution to GDP and employment are not immediately replaced, even if the demand is there - an application of the concept of
hysteresis as seen in other engineering disciplines.).
The experiment was halted when the economy started making pre-recessionary sounds, suggesting the neutral rate was lower than everyone's theoretical assumptions. Then it was utterly confounded by the pandemic. However, Fed officials who lived through the last 25 years probably have an eye on asset prices, in addition to inflation and unemployment numbers.
They're not supposed to be looking at asset prices though, even though we are all aware that asset bubbles can cause widespread unemployment.So maybe the Fed's concerns about asset bubbles are a band-aid over the flaws of their 2% inflation target, and a 3% target would produce a less forward-looking and bubble-prone investment zeitgeist, at the cost of ending some marginally profitable business projects. Or maybe we prefer a bubble-cycle economy to a business-cycle economy, because we believe we can either profit from or foresee the bubbles, whereas business-cycle recessions seem to come out of the blue.
