The economy could do well with inflation above 2%

United States Federal Reserve Building, Washington DC

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The Fed wants to bring inflation down to 2%. But the economy may be fine with higher inflation.

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  • The US Federal Reserve – and many other central banks around the world – have declared their determination to bring inflation down to 2%. But it is an arbitrary target criticized by some economists.
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The 2% inflation target has been repeated so often by Fed officials and central bankers around the world that it seems absolutely crucial to a healthy economy. But “the 2% inflation target is relatively arbitrary,” said Josh Bivens, research director at the Economic Policy Institute.

In fact, it was invented in New Zealand in the 1980s. Arthur Grimes, professor of welfare and public policy at the University of Victoria, said New Zealand was experiencing soaring inflation then, and that the central bank chose an inflation target – seemingly out of nowhere – so that it could work towards a target.

Other central banks have followed suit. In 1991, Canada announced its inflation target; the UK followed a year later. It wasn’t until 2012 that the US declared its 2% inflation target, but that number has remained stubbornly alive in the Fed’s mind ever since.

But while the 2% target is arbitrary, it implies that the economy could function normally at a higher level of inflation. Indeed, in 2007, some economists wrote a letter to the Fed arguing for a higher cap. “There is no evidence that inflation of 3% or 4% does substantial damage compared to inflation of 2%,” said Laurence Ball, professor of economics at Johns Hopkins University, who was doing part of the signatories of this letter.

However, the Fed is unlikely to change its target in the current hike cycle – it could appear to be caving in to investors’ demands for lower rates. Reconsidering what healthy inflation means will be a task for another generation of central bankers.

CNBC Andrea Miller contributed to this report.

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