2% Inflation — A Fool’s Quest
2% Inflation and the Fed


Every country has a central bank. Depending on the country, the responsibilities of the central bank might differ. Central banks could do any or all of the following:

  • Act as the government’s bank
  • Supervise banks and other financial institutions
  • Conduct monetary policy

This note focuses on the latter role.  Conducting monetary policy means that the central bank is in charge of making sure the country has just the right amount of money. Unlike you and I who would be convicted of counterfeiting, the central bank is given the legal right to create or produce money. In the U.S. the Fed does not actually do the printing of the money (the U.S. Treasury has the plates), but it does make the decision as to how much currency gets printed and how much is emitted into the economy.

Money is generally defined as the things that most people use to make final payment for the goods and services they purchase. This normally includes paper money, coin, checking deposits, and traveler’s checks.

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This brings up the difference between money and credit. Money is an asset that you use primarily for the purpose of buying things.

Credit may be used to obtain goods but notice that when you use credit you are chalking up a liability that has to be repaid.

So we think of money and credit as two very different things. This brings up the issue of credit cards and why we never consider credit cards as money. For one thing, you will need money to pay off at least part of your balance each month. So the money is already counting for those transactions. The part you don’t pay off is credit, or a debt that you will have to payoff with money in the future. Money is not the only thing that impacts spending but it is believed to have a regular impact on it. Credit also affects spending but its impact is generally kept separate from the impact of money.

This brings up the fact that there is more than one way to measure money. We begin with the concept or the definition – the idea that money is what we use to buy things. But how do we measure the amount of money in a country?

M1/Narrow Money

(these definitions may differ from country to country).

Is defined as the usual things considered to be money are currency, coin, checkable deposits, and traveler’s checks.

One criticism is that M1 may be too narrow to include everything used as money. You may have some very liquid (easy to liquidate or sell) financial assets that you could sell quickly to purchase something.

Such liquid financial assets include your savings account or a short-term asset like a 90 day certificate of deposit.

Because people do seem to regularly liquidate these short-term assets and use the proceeds for payments, we often include them in broader measures of money like M2 or M3. (For the purposes of this course, differences between M2 and M3 are not emphasized. It is important, however, to know that these broader concepts include some of the items mentioned in the box above.)

This discussion may sound like it is getting too technical for our macro purposes but it is necessary to understand one source of difference of opinion about policy. Most central banks publish data on these various definitions of money. When all the measures are performing in the same manner there is no real problem.

But what happens when we find that for the last 6 months M1 was growing rapidly while M2 has not? Is money growing too rapidly?

When you have two different indicators of money telling you two different things, then this creates a source of uncertainty for all of us for at least two reasons. First, we have conflicting signals about the growth of money. Second, because the central bank does not always share with us which of these measures they are using to guide policy.

So we can’t be too sure whether the Fed is about to rein in money that has been growing too fast or it is quite content with the pace of money growth.

The following chart contains monetary aggregates charts from the St. Louis Federal Reserve Bank. Notice that in the time period from 1990 to 1992, the chart that has M1 (top chart) shows money growth averaging about 10% per year – and its percentage change was increasing over those years. The second chart shows M2 growth. It is averaging less than 5% growth and the percentage change seems to be slowing or reducing each year between 1990 and 1992. Narrow money suggests a policy of monetary expansion while broad money seems to be indicating a tightening.  There is no easy answer as to which measure of money is the best one. If money growth is a good predictor of future economic activity and measures of money are not in agreement, then this adds uncertainty to our business lives. Most of us learn as much as we can about all the measures and the Fed’s behavior and use this knowledge in planning.  

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Now we know how to measure money, but what does it mean when we say that the central bank should provide just the right amount of money?  

One way to look at this is to say that the right amount is just enough money so that AD grows at a rate that will let the economy expand at an acceptable rate without inflation

The acceptable rate is usually identified with the growth rate of potential real GDP. Recall that potential real GDP is a level of output that is compatible with fully employed resources. U.S. history tells us that potential real GDP averages annual growth of about 3% per year. Not every country will have the same growth rate of potential real GDP. Nor does it necessarily stay the same over time for every country. Developing countries often can grow at rates much faster than that without generating inflation. In our note on aggregate supply we will discuss this topic in more detail.

If AD grew by about 3%, in most rich countries, that would be compatible with normal economic growth without inflation. It turns out that most countries do not necessarily want to have zero inflation. We will discuss this point more in our note on inflation. For now, let’s just recognize that most countries would be more than pleased to have an inflation rate in the range of 2-3% per year. (Of course, countries that have experienced and struggled with very high inflation in recent times would probably be happy with 5-10% inflation. It was not too long ago that Turkey’s inflation rate was growing at triple-digit rates). If a nation desires output to grow by 3% per year and the prices of that output are allowed to rise by 2-3%, then we are talking about a national goal of nominal spending rising by about 5-6% per year. If that country allows its money supply to grow by about that amount then it is using monetary policy to facilitate normal economic growth and its desired low inflation target.

The ECB and the U.S. Fed are interesting examples of central banks that adhere to the above basic philosophy but have very different explicit goal statements.

Charter says that the ECB should aim for price stability. The ECB interprets this as meaning an inflation rate of around 2% in the medium run. The ECB is not legally allowed to use potential real GDP or any other economic variable into its monetary policy goals. It has a simple goal. If inflation goes above 2% for a considerable period of time, then it must eventually  tighten money to bring inflation down. If inflation goes below 2% for a considerable period of time, then it should eventually loosen money so as to bring inflation back up to the goal value.

The following quote comes from the ECB website and explains their goal:

“To maintain price stability is the primary objective of the Eurosystem and of the single monetary policy for which it is responsible. This is laid down in the Treaty establishing the European Community, Article 105 (1).

Without prejudice to the objective of price stability”, the Eurosystem will also “support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community”. These include a “high level of employment” and “sustainable and non-inflationary growth.

The Treaty establishes a clear hierarchy of objectives for the Eurosystem. It assigns overriding importance to price stability. The Treaty makes clear that ensuring price stability is the most important contribution that monetary policy can make to achieve a favourable economic environment and a high level of employment.

The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.”

The Fed’s charter is not so specific and leaves room for it to consider a wider set of economic problems. Nevertheless, the Fed is quite clear that its #1 goal is to keep inflation low and stable. This comes from the recognition that when inflation gets high and variable, this can be very damaging for a country. So inflation is “public enemy #1.” If inflation is under control, however, and a short-run shock causes slow growth, high unemployment, or otherwise lower AD, then the Fed’s goals are broad enough to allow it to try to stabilize the economy. Sometimes people use the word “eclectic” to describe the Fed.

Eclectic means that it has more than one goal variable and it has the flexibility to decide which of those goals is of paramount importance at any given time

Some people think that eclecticism is good. Others, like those who framed the ECB charter, believe that fewer goals are better. If the Fed only has one tool then they should have only one goal. We will say more about this controversy below.

This quote about the Fed’s goal came from the web site of the Federal Reserve Bank of San Francisco, “The Federal Reserve has seen its legislative mandate for monetary policy change several times since its founding in 1913, when macroeconomic policy as such was not clearly understood. The most recent revisions were in 1977 and 1978, and they require the Fed to promote both price stability and full employment. The past changes in the mandate appear to reflect both economic events in the U.S. and advances in understanding how the economy functions. In the twenty years since the Fed’s mandate was last changed, there have been further important economic developments as well as refinements in economic thought, and these raise the issue of whether to modify the goals for U.S. monetary policy once again. Indeed, a number of other countries–notably those that adopted the Euro as a common currency at the start of this year–have accepted price stability as the new primary goal for their monetary policies.”

In an editorial “Resist the Siren Song,” the Financial Times expressed its clear opinion that both monetary and fiscal policymakers learn from the legend of Odysseus – and from recent Nobel Laureates. Odysseus was the one who asked to be tied to his boat’s mast so he wouldn’t be tempted by the beautiful but deadly Sirens. Nobel Laureates Finn Kydland and Edward Prescott discussed how policy makers should be time consistent (stick to their good long-run policies) and not have their attention diverted to short-term emergencies. Sticking to what is good in the long-run tends to keep inflationary expectations stable and the economy growing despite what appear to be short-run emergencies. The author credits the Euro system, the U.S. and the U.K. with having resisted Sirens’ Song and keeping their policy focused on low and stable inflation.

This debate goes beyond just monetary policy to any macroeconomic policy. The general idea is that if a policymaker has one goal then it may be best to have one instrument or tool with which to attain it. Trying to solve two problems with one tool is not generally feasible. It is better to have two tools. The implication for business people is to know that this debate rages on in the headlines and it provides information about central bank’s ability to achieve their goals.

An issue quite related to eclecticism is discretion. This issue of discretion contrasts this form of money management to one guided by explicit rules. A rule is like an equation – once it is put into force, the decision makers at the central bank are not allowed to alter it. Milton Friedman, a famous monetarist, once suggested that the Fed should increase the money supply by exactly 3% every year.  

The key to all these rules is that the behavior of the central bank is proscribed tightly by rules. For example, “gold bugs” might limit money supply increases to rate at which the central bank buys gold. Something like this was practiced during the gold standard in the latter part of the 19th century and early 20th century. Other economists might tie the growth of money tightly to a formula that relates money growth to inflation, or to output and inflation, or to a variety of other variables.  

The opposite of rules is discretion – meaning that the central bank policy makers meet periodically and reason with each other and then make decisions that seem most applicable for a particular time. People who favor rules are usually people who mistrust central bankers. The history of central banking is rife with examples that show why public oversight is important. Conservative economists worry that the potential for harm is great when central bankers are too free to make too many decisions. These economists prefer rules. Of course, the history of central banking has plenty of examples of good decisions. More liberal monetary economists often like to see more discretion used in policy. The Greenspan Fed was often given high marks by economists who believe the discretionary policy of the 1990s was pretty good.

Janet Yellen, the President and CEO of the Federal Reserve Bank of San Francisco wrote about the Greenspan Years in the FRBSF Economic Letter on January 27, 2006.

Here are some words aimed at Ben Bernanke, Greenspan’s replacement, as she evaluates the past record of the Greenspan Fed.

“While the Fed does not follow a policy rule, it has been consistent in its approach to achieving its dual mandate – keeping inflation low and stable and promoting maximum sustainable employment.”

She also noted that the Fed showed flexibility citing how they seemed to worry less about future inflation when they knew that productivity growth was very strong.

She then went on to say that another Greenspan achievement was in the area of communications. The Fed made monetary policy more understandable and transparent. “….the [Fed] press release has come to include a statement about the balance of risks to the attainment of its dual mandate, and at least some indication of where policy was going in the future.”

In a follow-up Article on March 17, 2006 (St. Patty’s Day) Yellen went on to conclude that the improvements in consistency and transparency have led to credibility. And here is what Yellen says about credibility, “But credibility is not only virtuous; it is also useful. I will argue that one of the most important benefits is shaping public expectations about inflation, and in particular, “anchoring” those expectations to price stability. As a consequence, credibility enhances the effectiveness of monetary policy….”

But this issue won’t go away quickly. More articles from economists at Yellen’s own bank appeared in FRBSF Economic Letter. On August 11, 2006 Eric Swanson argued after studying high-frequency financial data that if the Fed had an explicit inflation target US inflation expectations would have been better anchored in the past. In direct contrast on September 1, 2006, Bharat Trehan found that after recent oil price shocks in the US, inflationary expectations in the US performed no differently than inflationary expectations in countries where the central bank did have explicit inflation targets (Canada and the U.K.). Thus, the Fed does not seem to need inflation targets to be credible according to Trehan. Clearly the Fed will continue to study this important issue.