Olivier Blanchard on Inflation Targeting After 2022

The Blanchard Argument

Olivier Blanchard, MIT emeritus and Peterson Institute for International Economics senior fellow, has argued since 2022 that the Federal Reserve's 2% inflation target is too low for the post-pandemic policy environment. His case rests on several interrelated propositions about the post-COVID macroeconomic landscape and what monetary policy can effectively manage.

Why 2% Is Too Low

The natural rate of interest — the real policy rate that produces neither expansion nor contraction in equilibrium — has fallen substantially since the 1990s. Blanchard's empirical work, paralleling research by John Williams, Tom Laubach, and Lawrence Summers, places the current natural rate well below historical averages, perhaps 0.5-1% in real terms.

A 2% inflation target plus a 0.5-1% natural real rate produces a neutral nominal policy rate of 2.5-3%. The zero lower bound is therefore only 250-300 basis points away from neutral, leaving limited policy space when negative shocks hit. The 2008-2015 zero-interest-rate episode demonstrated that this constraint can bind for extended periods.

Raising the inflation target to 3% would, mechanically, raise the neutral nominal rate by 100 basis points and provide more policy space. Blanchard's argument is that this is a one-time adjustment that improves the policy regime without producing the kind of runaway inflation that the strict-2%-target framework was designed to prevent.

The Counterarguments

The case for keeping the 2% target rests on several propositions.

Credibility: the Fed has spent forty years building public expectations that inflation will return to 2%. Moving the target risks unanchoring expectations and producing the kind of inflationary expectations-driven dynamics that the framework prevents.

Welfare cost of inflation: higher inflation produces some welfare loss through indexation complexity, menu costs, and uncertainty effects. The 2% vs. 3% margin is probably small, but it is positive.

Distributional effects: inflation affects different households differently. Households with substantial fixed-rate debt benefit; households with savings in nominal assets are hurt. The distributional consequences of moving the target are complex and uncertain.

Communication risk: moving the target during a high-inflation episode looks like accommodation; moving it during a low-inflation episode looks like an admission of past failures. There may be no politically clean moment to make the change.

The 2025 Framework Review

The Federal Reserve conducts framework reviews on a roughly five- year cycle. The 2020 review produced the "flexible average inflation targeting" (FAIT) revision — which committed the Fed to running the labor market hot, accepting some inflation overshoots, until inflation actually rose above target. The 2025 review will be the first full review since the 2021-2024 inflation episode.

The review's likely topics:

• Whether FAIT has survived the inflation episode that tested it.
• Whether the 2% target is the right anchor (Blanchard's question).
• How to incorporate financial-stability considerations into the framework.
• How to handle supply-shock inflation (which the framework was not designed for).
• The role of forward guidance and balance-sheet tools in the post-zero-bound environment.

The review will not be dramatic. Fed reviews typically produce incremental modifications rather than wholesale framework changes. But the cumulative effect of the review's choices will shape Fed policy for the rest of the decade.

The Minsky Insight

Hyman Minsky's "financial instability hypothesis" — that long periods of financial stability encourage rising leverage that eventually breaks the stability — is the most-cited intellectual heritage of post-2008 financial-stability concerns. The 2010s low- inflation low-rate environment looked exactly like the conditions Minsky described: Treasury markets stretching duration, private credit growing rapidly outside bank balance sheets, commercial real estate building up debt against asset values that depended on continued low rates.

The 2022-2023 stress events — Credit Suisse, SVB, First Republic, the UK gilt-market dislocation — were the cyclical consequences Minsky's frame predicts. The inflation-targeting framework does not have good tools for the financial-stability concerns Minsky's frame implies. The "lean against the wind" debate — should monetary policy respond to financial-stability concerns even when inflation is on target? — has been argued for two decades without resolution.

What Minsky Implies for the Next Decade

If Minsky's frame is correct, the period of stability after the 2008 crisis was building the conditions for the next major disruption. The 2022-2024 stress was a partial release of those conditions. The full release — if Minsky is right — has not yet occurred.

The implications for Fed policy:

• Financial-stability concerns may need to take on more weight in the policy framework relative to short-run inflation deviations.
• Macroprudential tools (capital requirements, liquidity ratios, stress testing) may be more important than monetary policy for managing financial-stability risks.
• The Fed's emergency-credit tools may need to be expanded to cover non-bank financial institutions where the bank-style framework does not reach.
• The boundary between monetary and fiscal policy may need to be renegotiated to handle stress that the conventional toolkit cannot.

None of these are formally in the Fed's framework. All of them are consequences of Minsky's frame that the framework would need to address if it took financial-stability concerns more seriously.

The Open Question

The deepest question is whether monetary policy alone — operating on a single instrument (the policy rate) with a single primary target (inflation) — can manage the macroeconomic outcomes that modern economies require. The 2021-2024 episode suggested it cannot, at least without substantial supply-side improvisation. The 2025 framework review will test whether the institution recognizes this and adjusts, or whether it remains within the framework that the 1990s consensus produced.

Blanchard's 3% target proposal is one specific answer. Other proposals — nominal GDP targeting, price-level targeting, more explicit dual-mandate weighting — exist alongside it. The framework that emerges from the 2025 review will probably incorporate some elements of these alternatives without fully adopting any of them. Whether the resulting framework can handle the next major stress better than the current one handled the 2021-2024 episode is the empirical question that only the next stress will resolve.

Reading List

• Olivier Blanchard's PIIE working papers (2022-2024)
• Hyman Minsky, Stabilizing an Unstable Economy (1986)
• Larry Summers on secular stagnation (multiple)
• FOMC framework review documentation (2020)
• Lael Brainard's framework-related speeches