The Assumptions Behind the Federal Reserve’s Choice of 2% per Year Were Erroneous: Focus: ...The decision by the Federal Reserve in the mid-1990s to settle on a 2% per year target inflation rate depended on three facts — or, rather, on three things that were presumed to be facts back in the mid-1990s:
- That the long run Phillips curve was vertical even with an inflation rate averaging 2% per year, so that there was no production or employment cost of such a target.
- That the safe real interest rate would be positive and significant, so that a 2% per year inflation target would not entail disturbingly low levels of nominal interest rates that might lead to instabilities in velocity.
- That shocks to the economy would be small, so that the Federal Reserve would never seek to compensate with an interest-rate reduction in the range of 5% or more.
We now know that all three of these were and are false.
The easiest way to fix this problem would be to revise the Federal Reserve Act — perhaps to add “healthy rate of nominal wage growth” to the list of Federal Reserve monetary policy objectives.