In 2012, the Federal Reserve formally adopted an inflation target and set it at 2 percent, in line with the level chosen by many other central banks. In hindsight, this setting left policymakers with too little room to cut interest rates when they want to fight recessions. Many researchers have noted that if central banks raised their inflation targets—either individually or in concert—they could do a better job in the long run of keeping inflation near its target and the workforce fully employed. Reifschneider and Wilcox highlight an additional and less-noted consequence of raising the inflation target modestly: The economy could enjoy a temporary but substantial boom in employment and output as it adjusted to the increase in the target. Critical to generating this favorable outcome would be decisive action by monetary policymakers to ensure that the higher inflation target is achieved in a reasonably timely manner. In light of substantial transition benefits, as well as the long-run improvement in economic performance, the authors recommend that the Federal Reserve raise its inflation target to 3 percent as part of its next framework review.
The background notes and data underlying this analysis can be downloaded here [zip].