I read an interesting Brooking blog today that explained in simple layperson terms why the US Federal Reserve targets 2% inflation. The blog is here: The Hutchins Center Explains: The framework for monetary policy. The article links to lots of follow-up reading concerning the details. The last section explores a range of alternative measures the Fed might consider if it concluded (it leans this way) that the 2% inflation targeting is a tad out of date with current economic conditions. There are several alternatives to the 2% inflation target mentioned.
I can relate this topic to every day data and analytics. The 2% inflation number is a target, a key performance indicator (KPI). It is used in several ways. It is a communications device for consumers and businesses: if the Fed has credibility and the target is mostly met we will likely behave with the assumption that inflation will be close to 2%. This will help in terms of stability when making investment decisions. The target is also used by the Fed as a leading indicator. If the actual rate of reported inflation varies above or below the target for any significant period of time, the Fed should respond and take action to address the underlying issue in order to return inflation to its target. All well and good but that’s not quite what happened, in recent years, as the excellent blog explains.
But the interesting part follows from the exploration of alternative targets explored at the end of the blog. The list includes higher inflation targets (as in higher than 2%), price-targeting (prices themselves as opposed to inflation which measure price changes), and nominal GDP (i.e. real GDP adjusted for inflation). All alternatives have merits and challenges. But one thing the article does not do is explore the alternative tools, if any, the Fed might employ should the KPI change. And this is a real problem for all data and analytics uses of KPI’s, targets and metrics.
If we change the KPI without permitting or even seeking changing the forms of behavior used to control or influence the underlying processes, then are we not kidding ourselves? Why would anything change if we just change the KPI and don’t change behavior? If the Fed still only fiddles with interest rates and buying bonds (known as unconventional monetary or quantitative easing) then changing the KPI ought to change how those tools are used or introduce the need for new tools. This is not explained in the otherwise excellent article.
I actually pondered this fundamental issue some time ago, and specifically for this economic topic. The root dichotomy is that the independent central banks control monetary policy while governments control fiscal policy. Thus the Fed has to cope with fickle politicians who tax and spend to meet their goals (we all assume that those goals are our goals, right???), and whose policies change and impact the business cycle. The Fed is always in catch-up mode. It’s like the CEO and board controlling the overall cash budget of a firm yet managers can open their own checking and lending accounts with outside banks. The basic elements of the system are not aligned and so we tend to get stresses.
We have to remember back before we had independent central banks. Back then those same fickle politicians controlled monetary and fiscal policy. That didn’t work out so well over the long term. Hence the shift to independent central banks controlling monetary (e.g. interest rates) policy. Maybe we should give total control of fiscal and monetary policy to central banks and have politicians plead their case for each spending plan? That would be like business managers submitting a business cases for each and every initiative and strategy they seek to expand their own empires. Oh, hang on, that is how firms operate…. Mmmm…interesting idea….eh?
Sent from my iPhone. Excuse the typos.
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