Inflation is still higher than the 2% the Federal Reserve is aiming for, and maybe that is OK. That is, if we could just put aside the fact that we hate inflation so much.
Fed policymakers are poised on Wednesday to leave their benchmark federal-funds rate steady at the highest level in more than two decades, and inflation is the biggest reason. Their preferred measure of consumer prices, from the Commerce Department, was up 2.7% from a year earlier in April. That marks an improvement from April 2023, when it was up 4.4%, but still doesn’t show the kind of progress investors were hoping for at the beginning of the year, when they were betting the Fed would be cutting by now.
Before the pandemic, high inflation would have struck a lot of economists as a high-class problem.
Low inflation, extremely low interest rates and the tepid economic recovery following the 2008 financial crisis had led some prominent economists to push for a much higher target inflation rate than 2%.
The problem, as they saw it, was that the real natural interest rate—the inflation-adjusted rate that was just right to keep the economy running smoothly—had fallen. It put the economy in a perilous state: If a recession hit, the Fed didn’t have much scope for cutting rates before hitting zero. This “zero lower bound” problem meant that the Fed would need to turn to less potent ways to stimulate the economy, such as asset purchases. As a result, economic recovery would be halting, with millions of workers again cast into long periods of joblessness.
But a higher inflation rate would, over time, allow the Fed to set interest rates higher. Then, when the economy ran into trouble, the central bank would have more scope to cut rates before hitting zero. Olivier Blanchard, then the chief economist of the International Monetary Fund, in 2010 suggested a 4% target would do the trick. Another advocate of a higher target, Johns Hopkins economist Laurence Ball also thought 4% was the right number.
Before the pandemic, Jón Steinsson, an economist at the University of California, Berkeley, was sympathetic to the idea of setting the inflation target higher. Now he isn’t, and the reason is simple: He has come to realize that Americans detest what economists like him thought of as relatively modest amounts of inflation.
Consumer sentiment remains extremely low, despite low levels of unemployment and continued wage growth, and the inflation experience of the past few years seems to be a major reason. Even as the Fed’s favored inflation measure has moderated from the 7.1% hit in June 2022, prices are far higher than they were before the pandemic. And while economic models might suggest that people really shouldn’t hate inflation as much as they do, that isn’t a good reason to discount their feelings.
“I think we should be humble,” said Steinsson. “It may well be that people hate inflation for some reason that is good and valid. It’s very plausible that we as a field haven’t really had a lot of success in modeling and articulating these costs.”
Recent survey work conducted by Harvard University economist Stefanie Stantcheva and fellow researchers has underscored how much people dislike inflation. They found, for example, that people on average view a one percentage-point increase in the inflation rate as twice as bad as a one percentage-point increase in the unemployment rate. (The Labor Department on Friday reported that the May unemployment rate was 4%. Were that to rise to 5%, the ranks of the unemployed would swell by 1.7 million.)
Survey respondents’ reasons for disliking inflation weren’t just based on worries about rising prices eating into their buying power, but by a view that inflation is mentally taxing. Dealing with a straitened budget exacts a psychological toll as well as a financial one.
“It’s also an issue of complexity,” said Stantcheva. “Even if you didn’t tighten budget standards, inflation still requires you to rethink things all the time, to rebudget things, and it is basically a big cognitive load.”
Despite the recent experience, Blanchard, now at Peterson Institute for International Economics, thinks the Fed should eventually raise the inflation target to help insure against future zero-bound problems. But for the sake of the Fed’s credibility, he reckons inflation needs to get to 2% before that can happen.
For their part, Fed officials, including Chair Jerome Powell, have been adamant that the central bank can’t consider changing the target with inflation running at current levels. “This is not a time at which we can start talking about changing it. We have no instinct to do that,” Powell told lawmakers last year.
Laurence Ball of Johns Hopkins is sticking to his guns on a higher inflation target. He thinks that what really made people upset about the recent experience was its suddenness, with inflation going from below 2% just before the pandemic to its highest level since 1981 in short order. He notes that the Fed under Paul Volcker in the early 1980s is credited with conquering inflation, but that in the late 1980s inflation was around 4%.
“I think if people were used to a world of 4% inflation and that was the norm they would not be especially unhappy about it,” he said.
In his view, the Fed doesn’t need inflation to reach 2% just to later lift its target to 4%. Instead, policymakers could leave their 2% target in place formally, but be all right with never quite getting there. And then some years down the line, they could adopt a higher target.
Steinsson has come to adopt former Fed Chair Alan Greenspan’s view of the right level of inflation: when people don’t consider inflation a factor in their decisions. With that in mind, he thinks a 2% target makes sense.
—Nick Timiraos contributed to this article.