More inflation: desirable - A higher target: unfeasible

Economic opinion

In spite of a long period of extremely loose monetary policy, central banks in advanced economies continue to struggle to reach their inflation target of 2%. Yet, last June, American economists again called on the Fed to raise its inflation target. Somewhat higher inflation would have advantages, but in current circumstances a higher inflation target wouldn’t be of much help for that. Today, low inflation is the result mainly of supply side factors, making it extremely difficult for central banks to stir it up. By raising the inflation target now, central banks would run the risk chiefly of undermining their credibility. That would cause more problems than it would solve. As long as the economy continues to grow moderately, the low inflation should not stand in the way of a normalisation of monetary policy.

Price stability means 2% inflation

Most central banks aim at price stability. That’s not to say that prices should not change. On the contrary, in a well-functioning market economy prices should constantly adapt to changes in supply and demand. So the market exchanges signals between producers and consumers. Price stability refers to the general price level, the weighted average of all prices. The more stable that is, the more clearly individual price changes signal changes in consumer preferences or production costs. The sharper the signal, the more efficiently production and consumption can adapt. In addition to a more transparent functioning of the market, a stable general price level provides the advantage that wealth and income are not arbitrarily redistributed by unexpected price shocks. It lowers long-term interest rates by reducing the risk premium for inflation and contributes to financial stability.

The increase in the general price level is inflation. So, strictly speaking, price stability implies 0% inflation. In practice, central banks of major industrialised countries associate price stability with inflation close to 2%. That pragmatic approach recognises that sometimes measurements overestimate inflation. It may be that a price increase only reflects a quality improvement that is not always possible to adjust for. An inflation target of just over 0% leaves some room for that. A little inflation works as a lubricant for the economy. The game of supply and demand sometimes requires that prices or wages decrease. That’s often less pleasant. When the general price level continuously increases a bit, it is sufficient that some prices or wages just remain stable to realise the required relative price adjustments. In monetary unions, such as the euro area, that argument has an extra dimension. To the extent that in some countries inflation is lower, it can be higher in others. After all, the ECB keeps the average inflation for the euro area in mind. So differences in competitiveness between states can be eliminated more easily. Also innovation comes more easily in an environment with somewhat higher inflation.

The 2% target is also seen as a buffer against deflation, i.e. a decrease in the general price level. In the collective memory deflation is associated with the Great Depression of the 1930s – a ghost image no one wants to see again. Yet, deflation is not always, as it was then, the result of a lack of demand that makes the economy collapse. It can also result from better supply conditions, such as cheaper energy or raw materials, more efficient production methods by new technologies or more competition because of international trade. In that case, lower prices increase customers’ purchasing power. That stimulates demand. A broader look at history shows that deflation was not always detrimental (Borio, C. et al., 2015). Yet the message remains ambiguous, as, today, slightly higher inflation would ease the debt burden in our highly indebted economies.

The zero lower bound

Nowadays central banks communicate their inflation target. Transparency about the policy objective increases the predictability and effectiveness of the policy. By aligning their own expectations to the central bank’s objective, economic agents contribute to the realisation of the objective. Monetary policy also works by influencing expectations. Therefore the central bank’s credibility is crucial.

That’s even more the case with too low than with too high inflation. When inflation is too high the central bank raises interest rates. An upper limit does not exist. Conversely, too low inflation requires lower policy rates. It’s not so much the nominal interest rate that is important, but the real interest rate, i.e. the nominal interest rate less the expected inflation. Sometimes the real interest rate has to go to zero or even lower. Then the central bank can hit a limit. For a long time it was assumed that central banks could not bring the (nominal) interest rate below 0%: the so-called zero lower bound. Recently, a number of central banks, including the ECB, have done just that, but only to a limited extent. A large negative interest rate would indeed stimulate the holding of cash notes and create inefficiencies. Furthermore, negative interest rates erode savings income and hamper a normal functioning of the banking system.

Therefore, there is an actual lower limit of the policy rate, implying that a negative real interest rate is only possible with positive inflation expectations. When there is deflation the central bank cannot lower the policy rate sufficiently, and that limits its clout. It will have to resort to unconventional instruments, such as buying up debt securities. Such solutions may help for some time, but run into practical problems after a while. Moreover, they create dangerous spill-overs for financial stability.

A higher inflation target?

An inflation target above 0% is thus needed to make monetary policy effective. But how high should it be? In 2003, the ECB redefined its original target of up to 2% as “lower than, but close to, 2%”. The Fed officialised in 2012 its “2% in the longer term” policy. Against the background of the sluggish economic recovery in the aftermath of the financial crisis, calls were launched for a higher target. At nominal policy rates of 0%, a credible doubling of the inflation target would have made real interest rates two times lower. It would have stimulated the economy significantly. The strengthening of the economic recovery weakens that argument nowadays. Yet, last June American economists repeated a call to the Fed.

Indeed, another argument points to the decreased economic growth potential. That lowers the economic neutral nominal interest rate level (the sum of the real growth potential and the expected inflation). Consequently, the current cycle of monetary policy tightening is likely to come to an end at lower interest rate levels than in the past. The likelihood that the central bank hits the zero lower bound in the next cycle of monetary easing thus increases. A higher inflation target could prevent this as it also increases the neutral interest rate level.

However, raising the inflation target is not a panacea. Anyone who believes that regards inflation as a purely monetary phenomenon: if the central bank creates enough money, sooner or later inflation will increase. However, globalisation makes the world more complex. The current low inflation has probably more to do with favourable trends in supply conditions (international trade, technological progress), than with the negative consequences of a demand shortage. In such a context, central banks can hardly stimulate inflation without first causing large negative side effects. If they raise the inflation target now, central banks run the risk mainly of undermining their credibility. That would cause more problems than solve. After all a high-jumper who cannot pass one metre is not going to raise the bar to two metres.

Some more inflation would improve today’s economic conditions, but central banks can’t contribute very much to that in the short term. As long as economic growth continues at a moderate pace, the low inflation shouldn’t stand in the way of a normalisation of monetary policy .

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