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Within the G7 high-income economies, inflation rose from 1.6 percent in 2019 to 5.6 percent in 2021, and to 6.8 percent as of October 2022.
This story is part of a Prospect series called The Great Inflation Myths, which takes on the dominant orthodoxies mainstream economists and the Federal Reserve have been espousing about inflation and the need for interest rate hikes to tame it. The series was developed in collaboration with the Political Economy Research Institute (PERI) at the University of Massachusetts Amherst. You can read every piece in the series at prospect.org/
Since the mid-1990s, macroeconomic policy throughout the world has been dominated by a policy framework known as “inflation targeting.” The central aim is to maintain an economy’s inflation rate within a low single-digit range. Most high-income economies, including the U.S., Germany, France, Italy, the U.K., Japan, Canada, and Australia, operate with 2 percent inflation rate targets. Middle- and low-income countries generally operate with only modestly higher targets.
As defined by former Federal Reserve Chair Alan Greenspan, an inflation target is “a rate of inflation that is sufficiently low that households and businesses do not have to take it into account in making everyday decisions.” The motivation for operating macro policy with low inflation targets is to establish price stability as the main goal of monetary policy and macro policy more generally. The operating assumption is that other macroeconomic policy goals—including economic growth, maximum employment, and overall macro stability—can be most effectively achieved when price stability is recognized as the first priority.
Yet no serious body of research exists to support this claim. There is no evidence showing that economies at any level of development consistently experience stronger economic growth when inflation is maintained at less than 3 percent. On the contrary, our research finds that economies perform better at modestly higher inflation rates, within a 4–5 percent inflation range; and, in some circumstances, at higher rates still.
Of course, policymakers always need to have effective tools for controlling inflation at their disposal. But what constitutes “effective” inflation control policies under any given set of circumstances? And what are the trade-offs and real economic costs of aiming for a 2 percent inflation target as opposed to, say, a 4–5 percent inflation range?
The sharp rise in global inflation rates coming out of the 2020-2021 COVID lockdowns has only underscored the importance of these questions. According to the International Monetary Fund, the average inflation rate for the global economy rose from 3.8 percent in 2019, the year prior to COVID onset, to 6.4 percent in 2021, and 9.1 percent as of October 2022. Within the G7 high-income economies—the U.S., U.K., Germany, France, Japan, Italy, and Canada—inflation rose from 1.6 percent in 2019 to 5.6 percent in 2021, and to 6.8 percent as of October 2022. For the U.S. economy, the figures are 2.1 percent in 2019, 7.4 percent in 2021, and 6.4 percent as of October 2022.
In response to this post-lockdown inflationary surge, central bankers have been taking aggressive actions to bring inflation down to within the 2 percent target range. This has entailed raising the short-term interest rates that they control for the purpose of weakening overall demand in the economy and forcing up unemployment rates. The premise is that higher unemployment will weaken the bargaining power of workers relative to their bosses. This in turn will lower wages and labor costs faced by businesses. With labor costs falling, businesses will then feel less pressure to raise prices to protect their profit margins. Inflation will fall as a result. Federal Reserve Chair Jerome Powell acknowledged these policy aims clearly, if demurely, in a major speech last August. Powell predicted then that there would “very likely be some softening of labor market conditions” resulting from the Fed raising interest rates. The Fed has now lifted the key policy rate that it controls, the “federal funds rate,” from 0.08 percent as of March 15 to 4.33 percent as of December 29.
The Fed promises still more interest rate increases in 2023, even though inflation has already been falling for the past five months, with the average U.S. inflation rate at 2.4 percent between July and November. The main driver of lower U.S. inflation has been the restoration of the supply chains that broke down during the COVID lockdown and the Ukraine war—i.e., factors that are unconnected to the Fed’s policy to raise interest rates and weaken workers’ bargaining power. Nevertheless, the Fed and other major central banks are persisting in their program to throw millions of people out of work as the price to pay for achieving their economies’ 2 percent inflation target.
Two Percent Inflation Does Not Deliver Higher Growth
There is no evidence that pushing inflation down to a 2 percent target rate achieves any benefit with respect to an economy’s long-term growth performance. The three bar graphs below show the relationship between the growth of economies’ overall output (GDP) and inflation. We show this relationship for a total of 130 countries over the period 1960-2021. The 130 countries in the data set include all countries reported by the World Bank with populations over four million people. For our data sample, we exclude the years for any given country in which its inflation rate exceeded 40 percent. We assume that these hyperinflationary experiences will be harmful to countries’ economic well-being and therefore do not require further analysis here. (The GDP growth figures are medians. For simplicity, we refer to them as “averages.”)
As we see in the first bar graph, average GDP growth is 2.8 percent when inflation is negative and then rises modestly, to 3.2 percent, when inflation ranges between 0 and positive 2.5 percent. We then see that average GDP growth rises to 4.1 percent during the years in which inflation ranges between 2.5 and 5 percent. Average GDP growth then rises again to 4.7 percent when the inflation range increases to between 5 and 10 percent.
Average GDP growth does then drop off when the inflation range rises to between 10 and 15 percent. However, this drop-off in growth is modest, to 4.4 percent. Moreover, this average GDP growth figure is fully 1.2 percentage points higher than the 3.2 percent figure associated with the 0-2.5 percent inflation range. Even at the 15–20 percent inflation range, average GDP growth is, at 4.2 percent, a full percentage point higher than the 3.2 percent figure within the 0–2.5 percent range. Indeed, not until inflation ranges between 30 and 40 percent does average GDP growth, at 2.9 percent, fall below the 3.2 percent GDP growth figure within the 0–2.5 percent inflation range. Overall, these results offer no support on behalf of a 2 percent inflation targeting framework as promoting economic growth.
Of course, these results are highly aggregated, by combining all countries, at all income levels, into a single data sample between 1960 and 2021. But basically the same results obtain if we look at the 37 countries that the World Bank defines as “high income” (with average per capita income of about $13,000 or higher), and for the United States by itself.
As the second graph shows, for the high-income economies between 1960 and 2021, average GDP growth is at 2.6 percent when inflation ranges between 0 and 2.5 percent. Average growth then rises to 3.5 percent when inflation ranges between 2.5 and 5 percent. Growth rises again to 4.0 percent when inflation ranges between 5 and 10 percent. Average growth does then decline to 3.6 percent in the 10–15 percent inflation range and, again, to 2.9 percent when inflation ranges between 15 and 20 percent. But these GDP growth figures within the 10–15 percent and 15–20 percent inflation ranges are still higher than the 2.6 percent growth rate within the 0–2.5 percent inflation range.
In short, these results for the 37 high-income countries are consistent with those for the full set of 130 countries: There is no evidence demonstrating that these economies’ growth performance between 1960 and 2021 is stronger when inflation is within a 0–2.5 percent range. To the contrary, economic growth is higher, on average, at higher inflation rates up until the 15–20 percent inflation range.
Considering data for the U.S. economy by itself in the third graph, we are of course dealing with a much smaller set of overall observations. For example, within the full 1960-2021 period, there are only four years in which inflation exceeded 10 percent in the U.S. and only one year in which inflation is negative. Focusing on the 57 years in which inflation ranged between 0 and 10 percent, the same overall pattern still holds.
GDP growth averages 2.7 percent in the U.S. over 1960-2021 when inflation is within the range of 0–2.5 percent. But then average GDP growth rises nearly a full percentage point, to 3.6 percent, when inflation is within the 2.5–5 percent range. When inflation ranges between 5 and 10 percent in the U.S., GDP growth then dips to 3.1 percent. But this figure is still higher than the 2.7 percent average growth figure over the years in which inflation ranges between 0 and 2.5 percent.
In a longer version of this article, we also present results for countries at lower income levels and on a decade-by-decade basis. They show the same pattern. Economies are more likely to achieve higher GDP growth rates in association with inflation rates in the range of 2.5–5 percent, 5–10 percent and, even, for the most part, 10–15 percent.
Throughout the global economy generally, and specifically with the high-income countries, including the United States, the evidence suggests that they are paying a significant penalty in terms of forgone GDP growth when policymakers set an inflation target at 2 percent as the central goal of macroeconomic policy.
Controlling Inflation Without Attacking Workers
These findings underscore the importance of devising measures other than raising interest rates and unemployment as viable inflation control tools. For example, the Biden administration itself has proposed enacting windfall profit taxes and stricter antitrust enforcement. These would counter the excessive markups over costs that corporations have been able to impose due to the supply-side disruptions that resulted from the COVID lockdown and Ukraine war.
Additional policy tools include short-term controls on a few critical prices, such as oil, and tighter enforcement of speculation on the futures markets for oil and food. The types of infrastructure investments supported by the 2021 bipartisan infrastructure law can serve to loosen supply chain bottlenecks in the short run while raising productivity over the longer term.
Advancing a green-energy transition—including investments in both energy efficiency and renewable energy—will reduce dependency on volatile fossil fuel markets while also driving down CO2 emissions. The 2022 Inflation Reduction Act and comparable measures at the state and municipal levels will be important resources here.
Each of these alternative measures can reduce inflationary pressures without forcing up unemployment rates. But most mainstream economists and policymakers contend that these alternatives are not likely to be effective enough to bring inflation rates down to levels consistent with their economies’ respective 2 percent inflation targets. For example, the Harvard University economist Lawrence Summers described excess profit taxes as “dangerous nonsense” as an inflation control policy, comparable to Donald Trump proposing bleach injections to control COVID symptoms. But this view mistakenly assumes that a 2 percent target makes economic sense.
It may be that these other measures do not operate as forcefully and rapidly as pushing up interest rates if the aim is indeed to bring inflation down to a 2 percent target rate. But the evidence shows that it is not necessary to force down inflation to such low levels, especially given that raising interest rates can succeed in controlling inflation primarily through raising mass unemployment and weakening workers’ bargaining power. Indeed, the need for attacking workers’ bargaining power in the name of inflation control evaporates once we recognize that economies do not sacrifice economic growth while operating with somewhat higher inflation rates.
