What’s so special about a 2% inflation target?

It’s Fed Day again, and the Fed has to deal with inflation rates that remain stubbornly above its 2% target. Personally, I think that in the world we live in, a natural inflation rate for the US and most European countries is 3% rather than 2%, but Engin Kara from Cardiff University makes an interesting counterpoint.

First, my case for 3% inflation targets rather than 2%.

In the US and Western Europe, we face two major problems over the coming decade or more. The first one is an ageing population and a declining workforce. This demographic headwind leads to increasing shortages of labour, which in turn creates wage inflation and pushes inflation rates structurally higher. According to my calculation, this lifts the average annual inflation rate by about 0.5 percentage points over the coming decade.

Then there is the end of globalisation. I am not talking about de-globalisation or the fragmentation or localisation of markets. Rather, I think that going forward, we will no longer reap the benefits of ever-increasing globalisation and outsourcing to cheaper producers in emerging markets. I have written here how this increases prices for European and USS consumers. According to my calculations, this adds another 0.5 percentage points in structural inflation.

Add these two drivers together, and structural inflation should be one percentage point higher in the next decade or more than it was in the last twenty or thirty years.

Before you panic about runaway inflation (I have many German readers, after all), let me assure you that 3% inflation is no problem at all for financial markets or businesses. Empirically, businesses and stock markets alike can deal with inflation anywhere between 0% and 4%. If inflation rises above 4% to 5%, businesses start to suffer because end demand declines (cost of living crisis) and margins get squeezed as businesses struggle to pass on rising input costs to end customers.

Economically and financially, there is no fundamental difference between a 2% and 3% inflation target.

But Kara makes the argument that there is, and that once inflation surpasses 1.9%, businesses change their behaviour and monetary policy loses some of its effectiveness.

He uses microdata of the price changes of some 340,000 products sold to consumers in the UK from 2003 to 2021. Then he asks a simple question. If you are running a business in the UK and you see that your competitors are increasing the prices for their products. Should you increase the prices for your goods as well?

If the prices are trending structurally higher, a business needs to increase its prices to avoid a margin squeeze. The longer you wait for your price increases, the more money you leave on the table because you are paying higher input costs while charging the same output prices.

But if price changes are only temporary and inflation pressures decline after a while, then you are better off keeping your prices low because your input costs will come back down again, and you can retain your margin while offering your products at a lower price than your competitor. By raising their prices, your competitors have effectively put themselves at a disadvantage the moment input costs drop again.

Kara shows empirically that once price increases surpass 1.9% in the UK, businesses tend to change their behaviour. If competitor prices increase just a little, businesses tend to ignore these prices and count them as a competitor reacting to firm-specific strategy decisions or firm-specific cost issues. Once price increases by competitors surpass the typical annual price increase (which for most industries in the UK happens to be around 1.9%), firms take the price changes of competitors as a signal that the cost pressures they see are a universal and persistent cost pressure. Hence, they decide to follow suit and raise prices themselves as well.

The result is that once inflation rates for individual products rise by more than 1.9%, this herd behaviour reinforces inflation trends. With every company that joins in the trend of raising prices, consumer price inflation accelerates a little bit, and you start to get an inflation spiral.

This behavioural change has two implications. First, there seems to be a ‘natural rate of inflation’ which in the UK is around 2%. If inflation remains above that level for too long, an economy becomes increasingly prone to self-reinforcing inflation loops.

Second, monetary policy becomes less effective once inflation rates surpass this natural rate of inflation. Because businesses are increasingly busy trying to monitor and emulate their competitors’ price actions, they pay less attention to monetary policy incentives, and hence changes in interest rates by the Bank of England have to become larger and more aggressive to break the inflation loop.

I find this an intriguing observation, but my counterargument is that it is based on the past behaviour of businesses during a period of low and steady inflation when the Bank of England focused on an inflation target of 2%. If the Bank were targeting 3% instead, would firms change their behaviour only once competitors start raising their prices by more than 3% rather than 2%? How did behaviour change during the recent inflationary episode, 2022 to 2023 (the analysis only uses data to 2021)? How did companies behave in the 1970s? I don’t know the answer, but it would be good if someone could check.