Should The Federal Reserve Raise Its Inflation Target?

Abstract

Standard economic reasoning shows that higher inflation imposes higher tax rates on money balances and unindexed savings, causing financial losses to households and reducing their real incomes. The leading cases for the Federal Reserve to raise its inflation target-that more inflation better "greases the wheels" of a sticky-wage economy, or that it beneficially keeps us farther above the zero lower bound on nominal interest rates-rest on supposed gains from higher inflation that do not plausibly outweigh the losses. The "grease" argument that a lowinflation regime reduces employment and real GDP is inconsistent with historical experience under low-inflation regimes. The argument that the inflation target should be raised to give the Federal Reserve "more ammunition" to fight recessions overlooks effective and less costly methods for conducting counter-recessionary monetary policy, in particular quantitative easing.

Keywords: Monetary policy, inflation target, optimum quantity of money, inflation tax, sticky prices, zero lower bound

JEL Classification: E42, E52