Prices and Choosing a Target Inflation Rate

The last time the Federal Reserve Bank (Fed for short) announced its inflation rate target, it was 2%. Discussing a good target rate seems almost like a joke, with inflation now running at more than 9%. What difference does a target make when the Fed misses its mark by that much?

Let’s think about it anyway.

Prices play an essential role in an economy by informing businesses and consumers about the relative cost of different purchasing options. Should you eat dinner at a more expensive restaurant you enjoy, or save some money for other things by eating at a restaurant that’s not quite as good? You look at the price difference and decide whether the nicer restaurant is worth the extra money.

Should an aircraft manufacturer fabricate parts from carbon fiber, which saves weight and increases fuel efficiency, or use aluminum, which costs less? It will examine the price difference and decide whether the lighter weight part is worth the extra money.

When something becomes more expensive, that signals purchasers that they might do better to reduce their purchases of a more expensive item and look for alternatives. When something becomes less expensive, that signals purchasers that it is more affordable and that they may want to purchase more of the less expensive item instead of something else.

In the absence of inflation, the price signal is clear to potential purchasers. Higher prices mean lower affordability; lower prices mean greater affordability. Inflation complicates that calculation because, during inflationary times, the potential purchaser must figure out whether the higher price is due to inflation or if it signals that the item is less affordable.

If inflation is running at 9% and the price of something goes up by 5%, is it more affordable or less affordable? It depends. What if the price had already risen by 6% two months ago? During inflationary times, price signals are distorted, making it more challenging to evaluate the prices of some things relative to others.

This line of reasoning suggests that the best target inflation rate is 0%, so potential purchasers can just look at the prices of individual goods to see whether they are up or down rather than figure out the effects of inflation.

Even 0% may be too high. Suppose prices signal to purchasers whether things are more or less expensive. In that case, they should fall when productivity increases, making things cheaper to produce. For example, suppose productivity increases by 3% a year. In that case, average prices should fall by 3% to reflect the lower cost of producing things.

Prices contain the most information to purchasers (and sellers) when they reflect the real cost of the items being purchased, which means that in general, prices should be falling and the best target inflation rate would be negative—deflation.

Economists tend not to like deflation for a few reasons. They say wages tend to be sticky downward, so layoffs tend to be used rather than pay cuts. Inflation is a way of reducing real pay without lowering the dollar pay of employees.

Also, they claim that falling prices will reduce demand because purchasers will be incentivized to wait to buy to get a lower price.

These arguments are questionable. One only has to look at consumer electronics, where prices have been falling for decades and business is booming, to see that falling prices do not have pernicious effects on demand. And, the last time prices steadily declined in the US economy, the economy grew substantially.

That last time was in the late 1800s. Data from the Minneapolis Fed shows that retail prices declined by 34% from 1870 to 1900, during the rapid industrialization of the US economy. It appears that growing prosperity and steady deflation are not incompatible.

To maximize the informational content of prices, the target rate of inflation should be negative, not the 2% that the Fed is targeting. But as I said at the outset, it seems almost ludicrous to discuss the Fed’s inflation target when it misses its target by so much.

Randall G. Holcombe is a Senior Fellow at the Independent Institute, the DeVoe Moore Professor of Economics at Florida State University, and author of the Independent Institute book Liberty in Peril: Democracy and Power in American History.
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