Hi J. Powell: From Where the “NORM” of 2 Percent Inflation Target Come From?

Abstract

This paper questions the Federal Reserve Chairman J. Powell on the 2% inflation target as “global norm.” We first survey works on monetary policy ranging from the 60’s Milton Friedman till recently Robert Lucas, and find no academic nor empirical support for the 2% optimal inflation rate. We then present our model to estimate the optimal inflation rate and show that there is a concave relationship between inflation and welfare gain, where the optimal inflation rate reached at 3%. Since optimal inflation rate at the annual level varies by market condition, our asset pricing model suggests inflation rate to be targeted between 4 and 6 years not annually. Finally, there is a welfare gain of 0.06% by raising the inflation target to 2.54% for the year 2020. Collectively, the answer of from where the 2% norm come from is from nowhere, because there should not be a “norm” as economics conditions varies each year and we should have long term target not annual.