Finally, Policymakers Are Rethinking the 2% Inflation Target

A number of current and former of policymakers along with other public officials and analysts have started to debate whether the 2% inflation target is still a viable policy rule. The debate is long overdue, but the trouble with this new debate is that the focus is too narrow. To be sure, some think the inflation target has been set to low, which is probably true, but the main reason the price-targeting regime has failed is because the consumer inflation gauge fails to capture all of the cyclical movements in actual inflation.

Years ago policymakers made the argument that a price-targeting regime would lead to greater macroeconomic stability as a low and stable inflation rate is beneficial to sustainable growth and maximum employment. Yet, the economic results have not lived up to policymaker’s promises and one of the fundamental reasons lies in the problem with price measurement.

Indeed, operating with a price anchor places increased emphasis on the accuracy of the targeted price series, as it is essential for the price gauge to capture real-time changes in inflation. Unfortunately, today’s standard consumer price indexes (i.e., the consumer price index (CPI) or the personal consumption expenditure (PCE) deflator) are not properly constructed for a price-targeting framework, as they are hybrid price series that link market prices with non-market (or hypothetical) prices.

One of the major areas of controversy is in the measurement of owner housing costs, which represents the largest component of the standard price gauges. The original CPI included the change in house prices for both new and existing homes. Yet, today’s consumer price index does not as government statisticians have replaced house prices with a rent series, which is not based on an actual price but what homeowners could conceivably rent their house for.

That change in price measurement dramatically dampened the cyclical movements in consumer price inflation and created the impression, wrongly in my view, that actual inflation is always more stable and slow moving. That was most obvious during the 2000s housing bubble when house price increases were accelerating and recorded near and above double-digit increases for several years and yet reported consumer price measures showed owner housing costs (based on implied rents) were relatively steady and increasing no faster than general inflation.

Policymakers must be aware of the shortcomings of the standard price series in order to avoid following a policy stance that brings about unintended consequences. Even though government statisticians no longer include house prices in the standard price indices does not mean that the general public excludes house price inflation as part of their view on inflation or that the linkage between interest rates, credit availability and housing has changed in a fundamental way. In fact, house price inflation still shows its pro-cyclical bias and an acute sensitivity to interest rates.

Re-thinking the inflation-targeting framework is timely and important, but to merely review the price target and the not the price gauge as well could do more harm than good. That’s because even though inflation is a monetary phenomenon it’s the buying decisions of the general public and not policymakers that ultimately determine the type of inflation.

Thus, by merely raising the policy target on today’s consumer inflation index and running with a more accommodative policy for a longer period of time offers no guarantee that policymaker’s will end up with want they want, more general inflation. The risk is that inflation will continue to percolate in the areas of the economy where it currently resides (housing) and not in the published price indexes.

A 2% price target is probably too low, but the bigger mistake of the price-targeting regime is to think that today’s standard consumer price measures offer the same inflation clarity of years past. The old consumer price index, which included house prices, would be more suited for today’s inflation targeting regime. But that price series was thrown into the trash bin because critics argued that it overstated general inflation. Yet, one of the lessons from the Great Financial Crisis is that it is probably better to operate with a price series that overstates inflation than to have one that misses it completely.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.