Has Janet Yellen Given Up On Her 2% Inflation Target?

Or, more precisely, has it become a ceiling rather than a target?  Among those who see Janet Yellen's first press conference as Fed Chair and the reports of the first FOMC meeting she chaired as indicating that 2% is now a ceiling to be approached from below rather than a target that could be approached from above are Tim Duy and Dean Baker.  I am not sure if it is true, but that would suggest that the initial reaction of the market that interest rate rises may be coming sooner than previously thought may be true, despite the welcome abandonment of a 6.5% unemployment rate trigger point, given the continuing declines in labor force participation by working age persons.  If indeed the ceiling argument is correct, what might lie behind this?

First we need to remind ourselves where this 2% inflation target came from and Yellen's crucial role in its initial policy adoption by the Fed and its subsequent spread.  Inflation targeting had been going on in various countries since 1990, beginning with New Zealand.  But until 1996 it was mostly smaller nations that were doing so and the targets they adopted were rarely 2%.  However, in that year her husband, George Akerlof, and two  others at Brookings, Dickens and Perry, published a paper that suggested that a 2% inflation rate might balance off the need to control inflation with the need for microeconomic labor market adjustments by changing real relative wages.  That a positive rate of inflation was needed for this was due to the empirical ubiquity of downward stickiness of nominal wages.  In the face of this the only way to get changes in real relative wages was to have wages for relatively scarce kinds of labor nominally rise.  There was in fact no rigorous derivation of a specific rate of inflation that would be optimal for this balancing act, but 2% was essentially thrown out as a possible level that might do the trick.  In that year, Janet Yellen convinced Alan Greenspan of this argument in private conversation only revealed later as Fed transcripts became public, with Greenspan shifting from a zero rate of inflation target to the 2% level, even though throughout his Fed chairmanship, there never was any official target level, with this holding even well into the chairmanship of Ben Bernanke, even though it was widely known from not long after 1996 that 2% was effectively the de facto Fed target inflation rate.

Given that decision, this target gradually spread throughout most of the other leading central banks, so that in recent years to varying degrees it has been either the official  or de facto target of the Bank of England, the Bank of Japan, the Bank of Canada, and the European Central Bank, among others.  It has effectively become the world target inflation rate, and in fact inflation rates in both the US and Canada tracked it fairly closely over quite a few years, whether due to the effects of conscious monetary policy or for other reasons.

However, in recent years the rate has drifted downward in many of these countries, including the US as well as the Eurozone, closer to 1% than 2% in the latter.  In practice, the rate has been in the 1-2% range for  many of these countries for several years.  Clearly, if 2% is the target, this suggests that expansionary monetary policy should be followed, and while indeed this has largely been the case, we have now seen several months where this stimulus has been gradually scaled back in the US with the "taper" policy that is steadily reducing the rate of QE3 expansion of the Fed base, with this expansion targeted to stop by the end of the year.  The push to move to a 2% inflation rate seems to be taking a back seat to fears of inflation rising too rapidly, perhaps through asset bubbles.

As it is, while the ECB does not seem to have been pushing too hard to be expansionary, some other central banks have recently been making dramatic efforts to be more expansionary, notably in Japan with Abenomics, however while failing to get to the 2% target.  As it is, the 2% target remains in place pretty much in all these countries, even as none seem to be achieving it.  What is going on?

One possible explanation is that in effect there has been a loophole to the downward nominal stickiness of wages.  It is not that lots of workers are now accepting nominal wage cuts in their current jobs, although more have done so to some extent .  Rather what has been going on has been the phenomenon of workers getting laid off and then rehired at other jobs at lower wages.  Few in place wages have fallen in nominal terms, but many actual workers have experienced nominal cuts due to being laid off and rehired at lower wages.  This may have become the loophole that is making it hard to achieve the 2% target.  This is regrettable, but it may be that Yellen and her colleagues have observed this and that it is what lies behind this shift to making the widely publicized 2% target into a ceiling, with that suggestion by Akerlof, Dickens, and Perry now having been effectively revised, if not so loudly in a public way.

Barkley Rosser