Inflation Target Reassessed: Is a 2% Rate Too Low for a Changing Economy?

The Federal Reserve is facing stubbornly high inflation rates that remain above its 2% target. Engin Kara from Cardiff University suggests that a natural rate of inflation for the US and most European countries could be 3%, rather than 2%. This would be due to two major problems: an ageing population and a declining workforce, which leads to increasing shortages of labor and wage inflation, structurally lifting the average annual inflation rate by about 0.5 percentage points over the coming decade. Additionally, Kara argues that the end of globalisation will increase prices for European and US consumers, adding another 0.5 percentage points in structural inflation.

Kara's argument is based on microdata of price changes of some 340,000 products sold to consumers in the UK from 2003 to 2021. He found that once price increases surpass 1.9% in the UK, businesses tend to change their behavior and raise prices themselves, creating a self-reinforcing inflation loop.

However, Kara's observation is based on past behavior during a period of low and steady inflation when the Bank of England focused on an inflation target of 2%. It remains unclear whether firms would change their behavior only once competitors start raising prices by more than 3% rather than 2% if the Bank were targeting 3% instead.