The story of the 2% inflation target starts oddly in New Zealand. In 1989, New Zealand wanted to codify the independence of its central bank, and in this bill, it directed the New Zealand finance minister and head of its central bank to come up with an inflation target (Irwin 2014). If this target was not met, then the head of the central bank could be fired. According to David Caygill, New Zealand’s finance minister at the time, “Inflation targeting wasn’t from our point of view the main point of the act,” and establishing the bank’s independence from political processes was far more important (Irwin, 2014). There were some concerns that a target would lead to higher employment, but the main opposition to the inflation target was in the hospital at the time. Once the bill became law, then an inflation target had to be chosen. In an off-hand remark in an interview, the former head central banker said the inflation target should be zero to 1 percent. However, Don Brash, the head of the central bank, claimed “It was almost a chance remark,” and “The figure was plucked out of the air to influence the public’s expectations ”(Irwin, 2014). They used this number as a starting point and pushed it up to 2% to give themselves a bit more room.
One could easily believe that an arbitrary number based on lack of political opposition and an off-hand comment by a central banker would not have much effect, but that assumption would be wrong. Once the central bank said that inflation would be 2%, everyone else assumed that it would be too, since the central bank could use monetary policy to change the inflation rate. For example, contracts assumed a 2% inflation rate, which means wages would only rise 2% a year. This meant that costs only would have to rise 2%, meaning that inflation slowed. It also got rid of the inflationary cycle where one buys goods now since they now believe they will be much more expensive later, creating a shortage of goods and an increase in prices. In 1989, the inflation rate was 7.6% in New Zealand, and by 1991 it was 2%. Countries started to take notice, and Canada and Britain implemented inflation targets shortly after (Irwin,2014).
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The United States was having a debate about the inflation rate the Fed should target, at the same time. Paul Volcker, who was Fed chair from 1979 to 1987, and his succeeding Fed Chair, Alan Greenspan, who served during this time period and until 2006, favored an inflation rate that was 0% to 1% (Sommer, 2023). They argued that this target was minimal enough to not affect business decisions, and prices would stay stable. However, Fed Governor and later Fed Chair, Janet Yellen, favored a higher inflation target that would allow for the Fed to take greater action if there was a recession (Sommer, 2023). She argued that, if there is a recession and the inflation rate is already very low, then there would be a high risk of deflation. Although the idea of a more valuable dollar may sound great, many economists think it is worse than high inflation (Engeman, 2019). The problem is that the value of money would increase when people do nothing with it. This would be problematic since people would not invest or spend money to get the country out of a recession when they could just get a return from doing nothing. Instead of taking a risk and investing the money, the velocity of money decreases, and there is less spending leading to higher unemployment and less growth. The cycle could then create more deflation and less spending, putting the country into a self-fulfilling recession cycle.
During the late 1990s, Japan saw the deflationary fear come true, where a deflationary economy created a decades-long stagnation. Combined with the mild 2001 post 9/11 recession, the argument to have a higher inflation target in the U.S. was strengthened (Irwin,2014). Thus, the implicit 1% target started gradually increasing. One analysis of FOMC meetings found that the Fed preferred an implicit target of 1.5 core inflation from 2000 to 2007 (Shaprio, Wilson, 2019). However, after the 2008 recession, the consensus shifted to a compromise of 2% inflation target in line with New Zealand, which was later made official in 2012 by Fed Chair Ben Bernanke, which is still in place today (Shapiro, Wilson, 2019).
So in short: original intent for 0-1% range for price stability. Adding a 1% buffer to allow for better influence during a recession. Japan's deflation in the 90s spooked all, while New Zealand's...
So in short: original intent for 0-1% range for price stability. Adding a 1% buffer to allow for better influence during a recession. Japan's deflation in the 90s spooked all, while New Zealand's success gave credence to accepting a higher range. Giving today's acceptable range as 1-3% and midpoint as target of 2%.
There are a few things this quote made me think of. This kinda has the assumption of supply-side economics: The wealthy are job creators, and thus all economic activity can only happen with them...
The problem is that the value of money would increase when people do nothing with it. This would be problematic since people would not invest or spend money to get the country out of a recession when they could just get a return from doing nothing. Instead of taking a risk and investing the money, the velocity of money decreases, and there is less spending leading to higher unemployment and less growth.
There are a few things this quote made me think of.
This kinda has the assumption of supply-side economics: The wealthy are job creators, and thus all economic activity can only happen with them moving their dollars.
This is somewhat at odds with the fact that a profitable endeavor will still be more profitable than waiting out deflation for returns, provided that deflation is also within reasonable bounds...10% deflation is just as bad as 10% inflation.
I'd like to see an economy that prioritizes asset-building over debt manipulation. I think it would help end these boom/bust cycles.
I think that there's been this presumption in the 21st century: That debt is a good thing, and anything that reduces demand for debt or makes it harder to pay down debt is bad.
I'd posit that the 'ideal' inflation is somewhere between -1% and 1%, with the caveat that interest rates should target around around 5% to allow that to happen. And that debt is an undesirable thing that we should seek to eliminate from the economy as much as possible.
The biggest problem we've faced is that interest rates have perpetually been so low over the last 30 years that the next deflationary crisis there's not gonna be any 'wiggle room' left for the fed.
I'm not wild about that quote, but it's in the right direction. Another way to think of deflation is that it's forcing a minimum interest rate. A 2% deflation rate means that holding cash is...
I'm not wild about that quote, but it's in the right direction. Another way to think of deflation is that it's forcing a minimum interest rate. A 2% deflation rate means that holding cash is equivalent to getting about a 2% interest rate in real terms. That's higher than it sounds. Here's a graph of the US 1 year interest rate in real terms. Deflation means that there is less room for the central bank to lower interest rates.
You thought of rich people first, but any long-term project, public or private, good or bad, is more expensive when interest rates are higher. Higher rates mean more short-term thinking, and lower rates encourage both long-term and more speculative thinking. It's a blunt instrument, but if you want to see ambitious things happen, lower rates are better. (And also, some sillier projects get funded, but they go together.)
The assumption that lower interest rates boost the economy is standard economics, not supply-side economics.
The main thing I'm pointing out is that we'd get much better price stability if we'd be willing to accept 'a little bit of deflation or a little bit of inflation' instead of 'a little bit of...
The main thing I'm pointing out is that we'd get much better price stability if we'd be willing to accept 'a little bit of deflation or a little bit of inflation' instead of 'a little bit of inflation or a lot of inflation.'
I disagree that high interest rates encourage short term thinking inside the scope of 0 debt.
I've seen this with my own eyes as a tale of two school districts. This is not a parable, it's a living example.
It's 1990 something. One school district paid down all their debts, and built up an asset pool over the course of 20 years. When it came time to upgrade the school, they were able to combine $1 million in grants with $5 million in assets, and build a brand new extension without increasing their constituent's tax burden.
The other school district maintained a bare minimum operating fund, while taking out debts for all capital improvements. Which means they are at the whims of interest rates whenever an unexpected cost comes up. Whenever a debt is paid, a new one takes its place. When the school needed more classrooms, they plopped a bunch of rented trailers down in the parking lot because they couldn't get approval to afford more capital debts.
You can probably see where I'm going with this. Because the real problems came as demographics shifted over the next 30 years.
The populations started shrinking in both school districts from their peak, as they were somewhat rural. On the order of about 200 households over the course of a decade. A continual drop totaling approximately $500,000 in income.
The school with assets was able to handle the dropping income without pay cuts or layoffs, they had the leeway in their annual budget to handle the fluctuations, mostly just reducing the amount being added to their capital fund when needed. Instead, they simply didn't replace a few retirees as they didn't need quite as many classrooms with the shrinking population. In the end, about 8 fewer staff and a smidge of belt tightening, but the capital fund still in tact and still growing at a reasonable rate.
The school with debt still had to pay down their debts. While they saved a bit on the trailer rentals when they weren't needed, it wasn't enough on its own. They needed to cut staff and do wage freezes. They had less and less wiggle room in their budget, and ultimately needed to take on more debt to afford some unexpected repairs. They needed to raise taxes to keep up.
The first school district maintained quality without raising taxes, which drew in some of the fluctuating population and their population drop stabilized over the next decade. Property values remained a stable rise and income raised again.
The second district saw its school rankings drop because of increased classroom sizes, from losing people, both firings and quittings. This exacerbated their population loss, resulting in higher tax rates as property values stagnated or dropped, as fewer people wanted to move to the worse school district.
Now almost 30 years on (as this process was ongoing since the early 90s), the first school district has been able to keep maintainence on there larger school, doing periodic renovations. Their tax rate is lower, property values are higher, and the school is still ranked a solid 7/10.
The other school has been petitioning to get debt discharged and other state aid, as quality continues to slip, and it becomes ever harder to afford to keep the lights on and the roof from leaking. They're ranked a 3/10 and barely keeping afloat.
This is the fundemental problem with debt-based operating: It relies on perpetually increasing income. It works well enough when populaton is growing, economy is expanding, and money is inflating.
If one or more of those factors is missing, things start faltering quickly.
We're seeing it now in higher education as well, where even a 2% drop in enrollment is causing cascading panic as the operational budget is so tight because there's so much mandatory debt payments to be made. There's not much in the way of a 'rainy day fund' for operational expenses...generally an endowment at best for larger universities.
In a steady-state economy targetting 0 inflation of prices, with a high enough interest rate encouraging savings (ie the feds are generating enough money to pay interest on savings in line with real economic growth), things will grow slowly. Jobs will be more stable, as companies will be more reluctant to hire additonal staff unless genuinely needed.
With debt as a more tangible and expensive liability, it will only be taken on if truely neccessary, and generally only if there's enough margin of assets to be certain of being able to afford it.
Inflation begets inflation, because wages need to rise with costs of goods. The curve over time will always trend upward.
However, by allowing reasonably small deflation, it allows the graph over time to be more of a sine curve.
I mean, sure, it’s nice to be rich, to pay off all your debts and be paid interest instead of paying interest. I’m generally in favor of avoiding debt if you can. Taking on too much debt is a...
I mean, sure, it’s nice to be rich, to pay off all your debts and be paid interest instead of paying interest. I’m generally in favor of avoiding debt if you can. Taking on too much debt is a common problem.
But how does that savings work? Investments compete for savers’ money. When the government offers high interest rates, many other investments are not worthwhile. People stop building.
I guess the government better build the new buildings, because there will be little reason for other people to do it.
I expect that you’re fine with that, but we’re pretty far away from deciding what a good inflation rate would be without changing everything else.
"We only have houses because only rich people build houses." My parents built a home for < $100,000 in the 80's. With a mortgage interest rate of almost 10%, and savings account rates around 4%....
"We only have houses because only rich people build houses."
My parents built a home for < $100,000 in the 80's. With a mortgage interest rate of almost 10%, and savings account rates around 4%. They were not particularily wealthy. But the burden of rent was still worse than the burden of interest.
The reality is that housing would be built, possibly subsidized. It probably wouldn't be targetted exclusively towards high-end luxury, as large debt loads would be increasingly untenable.
But even then, it is foolish to think a wealthy landlord would opt to keep assets in a savings account earning 5% interest instead of building an apartment building where they could get 10% or more annual profits on tenants paying rent.
What probably would take a nosedive is the stock market casino placing bets on future earnings or losses. Investments and valuations would more closely reflect actual current value, rather than hypothetical future values.
Add in some wealth taxes that start negating any gains beyond say $2 million, and all of a sudden there's little to no need to hoard the wealth, and the government is better able to spend heavily, or lower taxes on the lower incomes and reduce inequality.
That sounds more like mismanagement of a small organization than a justification for allowing deflation as part of our national target range. Most large organizations, including large...
That sounds more like mismanagement of a small organization than a justification for allowing deflation as part of our national target range. Most large organizations, including large universities, have a combination of cash reserves and bonds, with a statutory bond limit for state universities, and bond rating organization policing private institutions. The finance department should be maintaining a healthy balance between assets and debt, with a prudent mix of loans and bonds, as well as a safe mix of cash on hand, short, and long-term investments.
Every organization needs to monitor their run rate, days cash on hand, and investments, and tune as needed. Debt financing can be a huge benefit to allow for investment in plant and capital improvements. But you of course need to manage your debt load.
I'm not an expert on economics, but my understanding is that the general sentiment is that it is easier to curb high inflation than it is to curb deflation, and the impacts of deflation are more immediately damaging to an economy.
With or without deflation, there will always be organizations that fail to manage their financial portfolio.
And I think you highlighted something that I've unintentionally danced around: What you've stated is that the current system demands complexity to do something which can be handled simply. Income,...
And I think you highlighted something that I've unintentionally danced around:
What you've stated is that the current system demands complexity to do something which can be handled simply.
Income, expenses, assets, and liabilities. That's all there is. And all I'm proposing is a system that disincentivies taking on liabilities instead of incentivizing it.
I don't know if that is the case. All deflation does to the debt market is increase the real interest rate (real = nominal - interest). It doesn't remove any complexity. Organizations still need...
I don't know if that is the case. All deflation does to the debt market is increase the real interest rate (real = nominal - interest). It doesn't remove any complexity. Organizations still need to manage their cash on hand, their balance sheets, blends of investments, etc. That's just a practical matter of meeting payroll and maximizing return on assets.
What deflation would do is make it more expensive to debt finance projects. And you might go, well, good, people get into trouble with debt. And that is true. But it also increases costs of anything that does require financing. And there is a complex set of tradeoffs between monetary circulation, interest rates, monetary velocity, etc.
But ultimately, the reason for the 2% target is because it allows space for monetary supply policies to cool or heat up the economy and avoid recession. No target will reduce the complexity of the financial obligations of businesses to manage their cash, assets, debts, and investment portfolio.
From the article:
...
So in short: original intent for 0-1% range for price stability. Adding a 1% buffer to allow for better influence during a recession. Japan's deflation in the 90s spooked all, while New Zealand's success gave credence to accepting a higher range. Giving today's acceptable range as 1-3% and midpoint as target of 2%.
There are a few things this quote made me think of.
This kinda has the assumption of supply-side economics: The wealthy are job creators, and thus all economic activity can only happen with them moving their dollars.
This is somewhat at odds with the fact that a profitable endeavor will still be more profitable than waiting out deflation for returns, provided that deflation is also within reasonable bounds...10% deflation is just as bad as 10% inflation.
I'd like to see an economy that prioritizes asset-building over debt manipulation. I think it would help end these boom/bust cycles.
I think that there's been this presumption in the 21st century: That debt is a good thing, and anything that reduces demand for debt or makes it harder to pay down debt is bad.
I'd posit that the 'ideal' inflation is somewhere between -1% and 1%, with the caveat that interest rates should target around around 5% to allow that to happen. And that debt is an undesirable thing that we should seek to eliminate from the economy as much as possible.
The biggest problem we've faced is that interest rates have perpetually been so low over the last 30 years that the next deflationary crisis there's not gonna be any 'wiggle room' left for the fed.
I'm not wild about that quote, but it's in the right direction. Another way to think of deflation is that it's forcing a minimum interest rate. A 2% deflation rate means that holding cash is equivalent to getting about a 2% interest rate in real terms. That's higher than it sounds. Here's a graph of the US 1 year interest rate in real terms. Deflation means that there is less room for the central bank to lower interest rates.
You thought of rich people first, but any long-term project, public or private, good or bad, is more expensive when interest rates are higher. Higher rates mean more short-term thinking, and lower rates encourage both long-term and more speculative thinking. It's a blunt instrument, but if you want to see ambitious things happen, lower rates are better. (And also, some sillier projects get funded, but they go together.)
The assumption that lower interest rates boost the economy is standard economics, not supply-side economics.
The main thing I'm pointing out is that we'd get much better price stability if we'd be willing to accept 'a little bit of deflation or a little bit of inflation' instead of 'a little bit of inflation or a lot of inflation.'
I disagree that high interest rates encourage short term thinking inside the scope of 0 debt.
I've seen this with my own eyes as a tale of two school districts. This is not a parable, it's a living example.
It's 1990 something. One school district paid down all their debts, and built up an asset pool over the course of 20 years. When it came time to upgrade the school, they were able to combine $1 million in grants with $5 million in assets, and build a brand new extension without increasing their constituent's tax burden.
The other school district maintained a bare minimum operating fund, while taking out debts for all capital improvements. Which means they are at the whims of interest rates whenever an unexpected cost comes up. Whenever a debt is paid, a new one takes its place. When the school needed more classrooms, they plopped a bunch of rented trailers down in the parking lot because they couldn't get approval to afford more capital debts.
You can probably see where I'm going with this. Because the real problems came as demographics shifted over the next 30 years.
The populations started shrinking in both school districts from their peak, as they were somewhat rural. On the order of about 200 households over the course of a decade. A continual drop totaling approximately $500,000 in income.
The school with assets was able to handle the dropping income without pay cuts or layoffs, they had the leeway in their annual budget to handle the fluctuations, mostly just reducing the amount being added to their capital fund when needed. Instead, they simply didn't replace a few retirees as they didn't need quite as many classrooms with the shrinking population. In the end, about 8 fewer staff and a smidge of belt tightening, but the capital fund still in tact and still growing at a reasonable rate.
The school with debt still had to pay down their debts. While they saved a bit on the trailer rentals when they weren't needed, it wasn't enough on its own. They needed to cut staff and do wage freezes. They had less and less wiggle room in their budget, and ultimately needed to take on more debt to afford some unexpected repairs. They needed to raise taxes to keep up.
The first school district maintained quality without raising taxes, which drew in some of the fluctuating population and their population drop stabilized over the next decade. Property values remained a stable rise and income raised again.
The second district saw its school rankings drop because of increased classroom sizes, from losing people, both firings and quittings. This exacerbated their population loss, resulting in higher tax rates as property values stagnated or dropped, as fewer people wanted to move to the worse school district.
Now almost 30 years on (as this process was ongoing since the early 90s), the first school district has been able to keep maintainence on there larger school, doing periodic renovations. Their tax rate is lower, property values are higher, and the school is still ranked a solid 7/10.
The other school has been petitioning to get debt discharged and other state aid, as quality continues to slip, and it becomes ever harder to afford to keep the lights on and the roof from leaking. They're ranked a 3/10 and barely keeping afloat.
This is the fundemental problem with debt-based operating: It relies on perpetually increasing income. It works well enough when populaton is growing, economy is expanding, and money is inflating.
If one or more of those factors is missing, things start faltering quickly.
We're seeing it now in higher education as well, where even a 2% drop in enrollment is causing cascading panic as the operational budget is so tight because there's so much mandatory debt payments to be made. There's not much in the way of a 'rainy day fund' for operational expenses...generally an endowment at best for larger universities.
In a steady-state economy targetting 0 inflation of prices, with a high enough interest rate encouraging savings (ie the feds are generating enough money to pay interest on savings in line with real economic growth), things will grow slowly. Jobs will be more stable, as companies will be more reluctant to hire additonal staff unless genuinely needed.
With debt as a more tangible and expensive liability, it will only be taken on if truely neccessary, and generally only if there's enough margin of assets to be certain of being able to afford it.
Inflation begets inflation, because wages need to rise with costs of goods. The curve over time will always trend upward.
However, by allowing reasonably small deflation, it allows the graph over time to be more of a sine curve.
I mean, sure, it’s nice to be rich, to pay off all your debts and be paid interest instead of paying interest. I’m generally in favor of avoiding debt if you can. Taking on too much debt is a common problem.
But how does that savings work? Investments compete for savers’ money. When the government offers high interest rates, many other investments are not worthwhile. People stop building.
I guess the government better build the new buildings, because there will be little reason for other people to do it.
I expect that you’re fine with that, but we’re pretty far away from deciding what a good inflation rate would be without changing everything else.
"We only have houses because only rich people build houses."
My parents built a home for < $100,000 in the 80's. With a mortgage interest rate of almost 10%, and savings account rates around 4%. They were not particularily wealthy. But the burden of rent was still worse than the burden of interest.
The reality is that housing would be built, possibly subsidized. It probably wouldn't be targetted exclusively towards high-end luxury, as large debt loads would be increasingly untenable.
But even then, it is foolish to think a wealthy landlord would opt to keep assets in a savings account earning 5% interest instead of building an apartment building where they could get 10% or more annual profits on tenants paying rent.
What probably would take a nosedive is the stock market casino placing bets on future earnings or losses. Investments and valuations would more closely reflect actual current value, rather than hypothetical future values.
Add in some wealth taxes that start negating any gains beyond say $2 million, and all of a sudden there's little to no need to hoard the wealth, and the government is better able to spend heavily, or lower taxes on the lower incomes and reduce inequality.
That was 40 years ago. A lot of things were different, both land and labor costs.
That sounds more like mismanagement of a small organization than a justification for allowing deflation as part of our national target range. Most large organizations, including large universities, have a combination of cash reserves and bonds, with a statutory bond limit for state universities, and bond rating organization policing private institutions. The finance department should be maintaining a healthy balance between assets and debt, with a prudent mix of loans and bonds, as well as a safe mix of cash on hand, short, and long-term investments.
Every organization needs to monitor their run rate, days cash on hand, and investments, and tune as needed. Debt financing can be a huge benefit to allow for investment in plant and capital improvements. But you of course need to manage your debt load.
I'm not an expert on economics, but my understanding is that the general sentiment is that it is easier to curb high inflation than it is to curb deflation, and the impacts of deflation are more immediately damaging to an economy.
With or without deflation, there will always be organizations that fail to manage their financial portfolio.
And I think you highlighted something that I've unintentionally danced around:
What you've stated is that the current system demands complexity to do something which can be handled simply.
Income, expenses, assets, and liabilities. That's all there is. And all I'm proposing is a system that disincentivies taking on liabilities instead of incentivizing it.
I don't know if that is the case. All deflation does to the debt market is increase the real interest rate (real = nominal - interest). It doesn't remove any complexity. Organizations still need to manage their cash on hand, their balance sheets, blends of investments, etc. That's just a practical matter of meeting payroll and maximizing return on assets.
What deflation would do is make it more expensive to debt finance projects. And you might go, well, good, people get into trouble with debt. And that is true. But it also increases costs of anything that does require financing. And there is a complex set of tradeoffs between monetary circulation, interest rates, monetary velocity, etc.
But ultimately, the reason for the 2% target is because it allows space for monetary supply policies to cool or heat up the economy and avoid recession. No target will reduce the complexity of the financial obligations of businesses to manage their cash, assets, debts, and investment portfolio.