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Two percent inflation is essential to the illusion

Jared Bernstein in WaPo recently said, “Why is 2 percent the Federal Reserve‚Äôs inflation target? Because it is.” The idea being that the world’s central bankers and economists and money men pulled this number out of their left ears because they didn’t know what else to say.

But Martin Wolf actually gave a real answer to that question, which had been bothering me for years.

[E]xperience shows that the low inflation targets to which policy makers are committed are not high enough to ensure short-term interest rates can remain above zero in all circumstances….

His article is on another topic — the need for financial reform — but that sentence gave me an Aha! moment.

Interest rates have to be high enough so that people with money feel they’re getting something for it, even if in reality they aren’t.

If, in reality, they’re not getting anything then the honest interest rate would be zero percent. But who wants that? You might as well have kept your money in your mattress and saved yourself the fifteen cents of gas getting to the bank to open an account. Then, of course, nobody could use your money to make money. The powers-that-be are terrified of people deciding to keep their money in mattresses.

So it’s vital to give people the illusion that they’re getting something for their money. Obviously, if the best you can do is zero, a 10% interest rate (and 10% inflation) is a much more exciting illusion than 2%. But the problem with high inflation is it starts running away with itself and the whole economy lands in the shredder. Two percent, on the other hand, seems to be about the lowest return that still motivates people to buy bonds. (Wolf’s point is that 2% isn’t working. The illusion needs to be set higher, at 4% perhaps.) The fact that it’s fictional if there’s matching inflation doesn’t matter. Even professionals buy the things so long as there’s at least a small positive number attached. (They report their year-end results in ordinary numbers, not inflation-adjusted ones.)

It’s a shell game, in which you provide money in the hope of gain. By the time you find out it was all fairy money, it’s too late to do anything about it.

And that’s why there’s a 2% target for inflation.