The economy could be OK with inflation above 2%

The Marriner S. Eccles Federal Reserve Building in Washington, DC

Stephanie Reynolds | Bloomberg Creative Photos | Getty Images

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The Fed wants to bring inflation down to 2%. But the economy can manage just fine with higher inflation.

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

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

Other central banks followed suit. In 1991, Canada announced its inflation target; the United Kingdom followed a year later. It wasn’t until 2012 that the US announced its 2% inflation target, but that number has stuck stubbornly in the minds of the Fed ever since.

But if the 2% target is arbitrary, it means the economy could function normally at a higher inflation rate. Indeed, in 2007, some economists wrote a letter to the Fed calling for a higher ceiling. “There is no evidence that 3% or 4% inflation does any substantial harm relative to 2% inflation,” said Laurence Ball, an economics professor at Johns Hopkins University, who was among those who signed the letter.

However, the Fed is unlikely to change its target in the current cycle of rate hikes – it appears that it is giving in to investor demands for lower interest rates. Rethinking what healthy inflation means will be a task left to a new generation of central bankers.

CNBCs Andrea Miller contributed to this report.

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