Need for revisiting 2 percent inflation target

‘The stock market crash is – perhaps – the long-awaited signal of a US economic slump.…The market meltdown and impending recession come over two full years after the Federal Reserve started hiking interest rates to “fight inflation.” They are the direct, but delayed, consequence of that policy.

So, the Fed’s policy is finally having its intended effect – over two years after inflation peaked and began to fall, for reasons unrelated to the Fed’s policy. …Unemployment is up almost a full percentage point over the past year, and job creation is way down.

The number of newly unemployed, newly employed part-time for economic reasons, and those not in the labor force but wanting a job increased by over a million from June to July.

Claudia Sahm’s indicator of recession – a half-point increase in unemployment on a three-month moving average basis – is blinking red. The Sahm rule has held since at least 1960.’ – An excerpt from an August 6, Project Syndicate (PS) published article ‘High interest rate finally bite’ by noted economist James K. Galbraith

A dip of a little more than 100,000 jobs in terms of new additions to the economy in July for the US economy, when compared with the previous 12-month average, has sparked serious concerns that the US Federal Reserve has been slow to cut interest rates. An August 2, Financial Times (FT) article ‘Federal Reserve under fire as slowing jobs market fans fears of recession’ pointed out in this regard: ‘The employment report released on Friday showed companies added 114,000 positions across the world’s largest economy last month, significantly lower than the 215,000 average gain over the past 12 months. …

The data comes two days after the US central bank opted against lowering its benchmark interest rate, which has remained at a 23-year high of 5.25 per cent to 5.5 per cent since last July. In justifying the decision, chair Jay Powell said the Federal Open Market Committee wanted to see more evidence that inflation is headed back to its 2per cent target before following through with any monetary policy pivot.’

Economics Nobel laureate Joseph Stiglitz has instead supported a higher inflation target, indicating that the 2 percent target had no technical basis, but was just an arbitrary target, and needs to be revised upward in a world punctuated by likelihood of deeper shocks to aggregate supply, and advised against over-reaction to inflationary pressures in terms of unnecessarily high usage of interest rate to control inflation.

In a February 2022, PS published article ‘A balanced response to inflation’, he pointed out: ‘…rapid structural change often call for a higher optimal inflation rate, owing to the downward nominal rigidities of wages and prices (meaning that what goes up rarely comes down).

We are in such a period now, and we shouldn’t panic if inflation exceeds the central bank’s 2% target – a rate for which there is no economic justification. …What we need instead are targeted structural and fiscal policies aimed at unblocking supply bottlenecks and helping people confront today’s realities.’

Although the article appeared when Covid pandemic had not officially been declared to be over, yet the fast-unfolding nature of existential threats, including likelihood of ‘Pandemicene’ phenomenon, and significant level of geo-political tensions in the Middle East, the analysis of Joseph Stiglitz above remains valid.

Moreover, the structural changes going on in the world due to existential threats, and significant impact of artificial intelligence on global economy, for instance, to which Joseph Stiglitz pointed towards in the article above, and in an interview in December 2022 to ‘ABC News (Australia)’ and because of which he indicated that a higher inflation rate needs to be targeted.

In the interview, he pointed out in this regard: ‘Well first let me say, where that number 2 to 3 percent come from. It was pulled out of the thin air.

There was no scientific basis. It’s now become a convention that’s accepted. But, in fact, economic research argues that when the economy is going through a transformation, and we are going through a transformation – green economy, digital economy, post-Covid-19 economy – you want to have probably a higher rate of target for your inflation. …I certainly think that there is no danger in having inflation of 4 or 5 percent, possibly even higher than that for a short period of time.

You know, one doesn’t want to have runaway inflation, but there is very little evidence that going up to 4 or 5 percent will lead to runaway inflation.’

More broadly, this may even suggest that the chances of a soft landing in terms of recessionary concerns in the US are not only unfounded, but it is becoming all the more likely that the largest economy globally is heading for a recession of a hard landing nature.

In an August 05, New York Times (NYT) article ‘The economy is looking pre-recessionary’ by Nobel laureate Paul Krugman not only did he expect the likelihood for economy to enter into recession, he was also critical of the US Federal Reserve delaying decision to cut interest rate.

He pointed out in this regard: ‘The United States probably (probably) hasn’t entered a recession yet. But the economy is definitely looking pre-recessionary. And policymakers – which right now basically means the Federal Reserve – need to move quickly to head off the risks of serious economic deterioration.

It’s already clear that the Fed made a mistake by not cutting rates last week; indeed, it probably should have begun cutting months ago. …[The US Federal Reserve] should make a substantial cut – probably half a percentage point, rather than its usual quarter-point – at its next meeting, scheduled for mid-September.’

This, in turn, produces all the more worries for the global economy, especially in terms of aggregate global supply shock, given the fact that the economy next in line, China, is already struggling in terms of not continuing with its usually marvelous economic growth numbers.

In addition, a higher-for-longer insistence on keeping interest rate high, and cutting it mildly over months, not only will likely produce recessionary consequences for the global economy, but will also make it difficult to invest for meeting significant levels of existential threats-related spending needs; not to mention adding balance of payments-, and debt repayments-related pressures for developing countries, including Pakistan.

Copyright Business Recorder, 2024