A Case for a 3% Inflation Target

There have been calls for a 4% inflation target. But a 3% target would work better. Let me show you why.

I will use this chart that plots net profit rate with core inflation… (quarterly data since 1958!!!)

Net profit rate = Corporate profit rate – nominal interest rate

The plot has hugged and slid along two resistance lines since 1958. Below there is resistance to fall into deflation at the 0% inflation line. To the left is a resistance line for a 0% profit rate over the real cost of money.

Let me explain how that real cost of money boundary is calculated.

• First… corporate profit rate – nominal interest cost gives net profit rate.
• Second… When inflation is equal and opposite to the net profit rate, the real profit rate is 0%.

Here is an example…

• Net profit rate = 5% corporate profit rate – 3% nominal interest rate = 2%

So the profit rate is 2% over the nominal cost of money. But then we make core inflation -2% to take away that net profit rate.

• Core inflation = -1 * 2% net profit rate = -2%
• Zero real profit rate = 2% net profit rate + -2% core inflation = 0%

So basically the line with a -1 slope that crosses through the origin of the x and y axes, gives the line where the real profit rate goes to zero %.

ok… back to the graph…

Opposing Forces in the Graph

How might we explain the steadfast movement of the data points along the two resistance lines.

Well, we know that there is a resistance to fall into deflation, and there is resistance by corporations to have negative real profit rates.

How can we view the forces at play?

There are forces to increase profits which try to push the data points away from a 0% real profit rate.

There are forces which counteract the forces to increase profits, namely, labor power, perfect competition and price inertia.

These counterbalancing forces work against the forces by corporations to increase profits for themselves.

So for 58 years, the pattern has been solid!!! The data points moved within a definable range.

Could the data points break out into a new pattern farther away from the resistance lines? I do not think so… It has never happened in 58 years of data. The forces are pushed into a balance in the range defined by the red zone in the graphs.

A 4% Inflation Target?

So what if the Fed tried to have a 4% inflation target, like Paul Krugman advises? The zone of a 4% inflation target would probably be like this…

As the green zone sits at a net profit rate of 0%, we could logically conclude that the nominal cost of money would equal any corporate profit rate as a general rule. So if corporate profit rates get back up to 9% in the next recovery, we would assume a nominal interest cost over 7% so that the forces are balanced at a 4% inflation target.

There would never be a nominal interest rate of 7% if inflation was 4%. It is not going to happen. So then we assume a nominal interest rate of 2% to 4%, which would imply an upper limit on the corporate profit rate in a range of 2% to 4%. So corporate profit rates would have to come down a lot in the next business cycle.

Corporations are going to fight tooth and nail against the 4% inflation target.

What about a 2% inflation target?

Actually a 2% inflation target feeds right into the hands of corporations. They can have high profit rates above 9% and the forces still be balanced along the 0% core inflation line. The Fed helps them by keeping nominal rates near 0% due to the stubborn low levels of inflation which correspond to high net profit rates. Also, higher profit rates lead to lower labor share and lower effective demand.

The forces from corporations to push net profits as far right as possible have succeeded greatly in the last two business cycles. But they have succeeded too well, and the economy is sick because of it. A 2% inflation target has created an environment for this between the forces described above.

A 3% Inflation Target?

A 3% inflation target would be met with  nominal rates from 1% to 3%, which would imply corporate profit rates in a range of 3% to 5%. This is a healthier balance than what we have now. And healthier than a 4% inflation target which implies a monetary policy tending to seem too tight.

It seems more reasonable to have a 3% inflation target. Very high corp. profit rates would be avoided. Lower profit rates would imply higher labor share, which would increase the Effective Demand on the business cycle. Then there would be higher utilization of labor and capital.

The main idea is that a 3% inflation target would better avoid the part of the zone that slides rightward holding inflation rates at stubbornly low levels.  Then the Fed thinks they have to keep nominal rates low to try and raise inflation. But the inflation rate is basically just stuck low in a balance between the forces described above.

A 3% inflation target would lift us out of that low level inflation zone and give us moderate nominal rates. Corporate profit rates would be healthier for the economy as a whole.

Conclusion

So it is a good idea to raise the inflation target. The graphs above suggest that a 2% inflation target is too low, a 4% inflation target is too high, and a 3% inflation target would be more balanced.

The big question is… How do we get out of this rut of low inflation levels? I think the Fed has to raise nominal rates to start bringing down net profit rates, so that corporations feel the need to counteract with the force of inflation (y-axis) to support their profit rates.