A critique of proposals to raise the Fed's inflation target

During the last seven years, the unemployment rate fell from 10 percent to less than 5 percent, but policymakers say that there is still an under utilization of labor resources. Why? Because inflation is below the Federal Reserve’s2 percent target and GDP is below official estimates of potential GDP. Normally, in this situation the Federal Open Market Committee (FOMC) would lower short-term interest rates in order to stimulate aggregate spending. However,short-term interest rates are near zero—as low as they can go when people have the alternative of holding cash. Those who want to use lower interest rates to stimulate the economy also want a higher inflation target so that when the economy is at full employment nominal interest rates will be higher, and when something bad happens, policymakers will have more flexibility to lower interest rates before hit-ting the zero lower bound.In a Financial Times interview on April 20, 2015, Federal Reserve Bank of Boston President Eric Rosengren called on his fellow policy-makers at the Fed and around the world to consider raising their inflation targets. This article explains why a higher inflation rate is not a good idea.As a cyclical policy, it would do more harm than good and, as a permanent policy, would not take us to a better economy.I begin by reviewing the calls for more inflation, explaining the rationale that is put forward for each case. Next,I lay out the reasons why raising the inflation target would be a bad idea. In particular, raising the inflation target damages the value of inflation targeting as a nominal anchor. Moreover,I summarize what we have learned about thecosts of inflation, both anticipated and unanticipated. Finally, I explain why the perceived benefits suggested by advocates of higher inflation are ephemeral and not likely to be achieved in practice.