Yellen's Implicit Inflation Target

Janet Yellen, President of the San Francisco Federal Reserve Bank, who previously preferred an inflation objective of 1.5% in the long run, has changed her preference to 2%. A higher inflation preference is interesting coming off a period of history economists called "The Great Moderation" - a glorious time of low inflation, low unemployment, and steady growth. The higher inflation preference of Ms. Yellen is meant to give the Federal Reserve more room to respond to shocks. Indeed, the current deflation fears has caused the Fed to lower the Fed Funds Rate target to a range of 0% to 0.25%, which leaves little room to maneuver if the economy were to continue to deteriorate. A higher long run objective would give the Fed more room to cut. In Ms. Yellen's words:

“Thus, an analysis of the zero bound needs to incorporate greater volatility than experienced over the past quarter century. With respect to the equilibrium real interest rate, the global savings glut that helped restrain real interest rates may persist or even intensify after the recession is over, leaving us with only a small cushion against reaching the zero bound.”