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What Are the New Inflation Hawks Thinking?

After so many years of hand-wringing over disappointing US economic growth, it is odd to hear prominent economists sounding the alarm about the mere possibility of inflation. If anything, we should want an economy in which a higher federal funds rate is warranted.

BERKELEY – Back in 1992, Lawrence H. Summers, then the chief economist at the World Bank, and I warned that pushing the US Federal Reserve’s annual inflation target down from 4% to 2% risked causing big problems. Not only was the 4% target not producing any discontent, but a 2% target would increase the risk of the Fed’s interest-rate policy hitting the zero lower bound.

Our objections went unheeded. Fed Chair Alan Greenspan reduced the inflation target to 2%, and we have been paying for it ever since. I have long thought that many of our economic problems would go away if we could rejigger asset markets in such a way as to make a 5% federal funds rate consistent with full employment in the late stage of a business cycle.

There are three ways to accomplish this. One is to raise the inflation target back to the 4% range that prevailed during Fed Chair Paul Volcker’s tenure. Another is to boost demand so that a late-cycle federal funds rate of 5% would still be consistent with strong investment. And a third option is to flood the market with safe Treasury assets so that the safe-asset price premium on Treasuries falls, thereby allowing the late-cycle federal funds rate to increase.

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