Thursday, July 14, 2011

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


  1. I had not heard the "grease the wheels" argument. Neat.

  2. This can become quite a dangerous subject in terms of morale of a company's workforce, particularly a company operating in a union workforce environment. The company will need to remain sensitive to the differences in its non-union workforce pay scales, especially when the company is under pressure to cut costs under a significant lean strategy format. However, used effectively, this makes much sense.

    The company following this format should certainly not allow its non-union workforce to receive substandard pay increases while its union workforce to continue to receive contractually negotiated pay increases at a higher rate than salary counterparts. Simply, at a minimum, it should keep pay increases at least at pace with the union pay increases. Otherwise, morale can be severely impacted and productivity and overall performance will suffer. This becomes even more dangerous when performance is considered a key factor. Given the widespread differences in performance evaluation measures and the perceptions of the workers that receive the performance measures, a company should invest heavily in communicating expectations continuously through its measured year where workers pay increases depend upon.

    How long can a company "push the envelope" of taking this approach with regards to its workers that are, after all, the geese that provide the golden eggs? This can work in the short term, but in the long term when workers cannot keep up with the rising costs of general living expenses, morale will dive and performance will soon follow.

    Targeting inflation only makes sense, however it is important to note that even a measure of inflation must be taken with a grain of salt. Now more than ever the variables included in forming these indexes (including the CPI) are influential at all levels. The variables are all interdependent, acting on each other to influence the overall numbers. So even though a solid number is derived from an index like the CPI, many more factors of the economic environment must be taking into consideration going forward when considering inflationary measure. Matt Rognlie was headed in a good direction by adding weight to the portions of the "basket" of items included in an index. But continued evaluations of the environment must be included as we progress, especially with globalization growing at such an exponential rate.

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