Why target inflation at 2%, and what exactly should the Fed target?

Most central banks around the world target a 2% annual increase in prices, some more formally than others. The arguments for a 2% target include:


1. Deflation (falling prices) is so dangerous and hard to fix, that is better to leave a little cushion on the positive side.

2. Measuring inflation is hard. If statisticians don't fully account for how people change their purchases in response to relative price changes, then the reported inflation rate may overstate actual inflation. For example,  people drive less when gas prices go up and so use less gas. The reduction in quantity of gas consumed may not show up in inflation estimates (depending on which formula is used).  An inaccurately measured inflation rate of 2% might be consistent with an unchanged cost of living.

Note: The U.S. does produce an estimate of inflation that attempts to address changes in consumption patterns. This more accurate measure of inflation is not currently used in calculating COLA's (cost of living adjustments) for Social Security. If the current round of U.S. budget haggling is successful, that may change. The government would save a lot of money, but retirees would see smaller increases in annual income from Social Security.

3. A little inflation "greases the wheels" of commerce.

This argument in favor of a 2% inflation target requires further explanation.  For simplicity, let us focus solely on the major cost category of production, wages.

If ALL workers' nominal wages go up 2% but prices also go up 2%, then their real wage stays the same.  Recall: nominal wages = dollar amount printed on your pay stub, while real wages = nominal wages adjusted for inflation (a measure of how much stuff you can actually buy). Workers would only be happy in this scenario if they suffer from money illusion; they don't notice that they can only buy the same amount of stuff this year after their raise as they could buy last year before their raise.

However as discussed in Krugman's post, pay raises are NOT the same for all workers. See (7-9-2011) Why are wages still rising? by Paul Krugman.  Over time firms discover some workers are more productive than others.  At first glance, firms would like to give pay raises to some employees and pay cuts to others.  However, workers don't like pay cuts, and unions may make them near impossible. In addition pay cuts hurt morale and productivity, so firms don't like them either. Economists call this "downward nominal wage rigidity". Data shows that this phenomenon really does exist. See article mentioned in Krugman's post June 2010 NBER working paper) Some Evidence on the Importance of Sticky Wages by Barrattieri, Basu, and Gottschalk. 

Since firms find it difficult to lower nominal wages, firms respond by keeping some workers' nominal wages constant and raising the nominal wages of others.  If the inflation rate is positive, say 2%, unproductive workers save face by not getting a nominal pay cut - but the workers' real wages do go down (they can't buy as much of the now more expensive stuff).  By raising output prices 2%, firms can cover the cost of pay raises to their most productive employees without pay cuts to their less productive workers. In this way a little inflation "greases the wheels", and allows business to operate smoothly in spite of downward nominal wage rigidity.

Related research...
Some economists have proposed that central banks should target increases in nominal wages instead of increases in overall prices.  This might lead to a more stable economy, less prone to cyclical swings. From the discussion above, a nominal wage inflation target should also be set above zero, perhaps at 2%. For an excellent review of the long history of this idea, here are two other blogger's thoughts:

(July 2011) The Money Illusion

(5-2011) Why target the CPI? by Matt Rognlie

College Education & Opportunity Cost

In terms of rate of return, investing in a college education beats most alternatives, including the stock and bond markets. According to a recent Brookings research paper  (see Brookings paper), investing in a college education yields about a 15% annual internal rate of return.                              

This article provides a nice example of opportunity cost. Opportunity cost is a key concept in economics, but it is often poorly understood. Imagine you are at a decision point in life, a fork in the road. You can think of "opportunity cost" as the value of the road not taken. More formally, opportunity cost is the value of the next best alternative.  The opportunity cost from going to college is the foregone earnings you could have earned ($54,000).

Sometimes students have a hard time seeing foregone wages as a real cost. Suppose you decided not to go to college. You wouldn't fork over $48,000 for tuition and fees and you would pocket $54,000 from earnings. You would be $102,000 richer than your friends on the day they graduate from college.  Your friends would have forfeited their $102,000 to go to college.

Table based on Brookings paper, see NCES for tuition data

Note that the opportunity cost ($54,000) for a typical high school student is greater than the tuition cost at a 4 year college ($48,000). The tuition costs do NOT include room and board, since people must eat and sleep whether they work or go to school.  For most people, the gain in income from college ($570,000) far exceeds the combined costs of tuition and foregone earnings.

Admittedly some people, like Kobe Bryant, have a special talent that allows them to earn a huge salary without going to college. For these people, the opportunity cost of college is in the millions, and they are much less likely to go to college.  While some of the uber-talented still do go to college (think of starlets like the actress who played Hermione Granger), they presumably place a lot of value on the social, intellectual benefits of college and have a flexible earning schedule.  For the rest of us ordinary mortals, the 15% rate of return on a college education should be too good to pass up, especially when all the non-monetary benefits are considered.

For a note of caution on students loans and making sure you get something useful out of college, watch:

http://www.5min.com/Video/Evaluating-the-Costs-of-College-445269349

Evaluating the Costs of College

Returns for a full-time MBA also look good. Davies and Cline (2005) estimate that the internal rate of return on  a MBA was 18% and the average payoff time was about 9 years (time until extra earnings from MBA covered tuition and foregone earnings). The rate of return may actually be lower for top 10 MBA programs due to greater costs (see reference for Grady below for literature review).

BizEd (Jan 2005) The ROI on the MBA by Antony Davies and Thomas W. Cline

For EMBA students, you may already know that EMBA students' responses on surveys usually show more satisfaction with their MBA program than part-time or full-time MBA students. Since EMBA students do not forgo earnings, their payoff time is much quicker, closer to 4 years.

See:
 (1) Bruce, Grady (2010), Exploring the Value of MBA Degrees: Students’ Experiences in Full-Time, Part-Time, and Executive MBA Programs, The Journal of Education for Business, 85(1): 38-44. or 


(2) Executive MBA Council, Research on Return on Investment