Should central banks’ inflation targets be raised?

When new zealand’s parliament decided in December 1989 on a 2% inflation target for the country’s central bank, none of the lawmakers dissented, perhaps because they were keen to head home for the Christmas break. Rather than being the outcome of intense economic debate, the figure—which was the first formal target to be adopted by a central bank—owes its origin to an offhand remark by a former finance minister, who suggested that the soon-to-be-independent central bank should aim for either zero or 1% inflation. The central-bank chief and incumbent finance minister used that as a starting-point, before plumping for 0-2%. Over time, 2% became the standard across the rich world.

Should the somewhat arbitrary goal of 2% be changed? The question may seem a little churlish when central banks are so flagrantly missing their existing targets: annual inflation in America, Britain and the euro area, for instance, is running at around 9%. The Federal Reserve’s experiment with “flexible average-inflation targeting” has coincided with the central bank allowing inflation to get out of hand. Yet it is possible that raising the target might help prevent rich countries from returning to the low-inflation, low-growth malaise that was the rule for the decade after the global financial crisis. The idea therefore warrants consideration.

High inflation is painful. Even if wages keep pace with price growth, thereby preserving workers’ incomes in real terms, it undermines the function of money both as a unit of account and as a store of value. Contracts agreed at one point in time lose their worth rapidly, redistributing income and wealth arbitrarily between buyers and sellers or between creditors and debtors. Long-term investment and saving decisions become more of a gamble, as the case of Turkey illustrates. Inflation there is in the region of 80%.

Yet deflation carries its own costs, too. Worryingly for mortgage-holders and governments alike, it raises the value of debts in real terms, which can generate a self-sustaining depression as incomes keep falling relative to debt payments. That explains why central banks aim for a low but positive rate of inflation.

Deciding which low but positive number is desirable is trickier. Is a target of 2% actually superior to one of 3% or 4%, for instance, or does it merely owe its exalted status to tradition? The relative damage done by extremely high or accelerating price growth may be easily visible, but economists have struggled to identify differences in the costs to an economy from different stable, low-single-digit inflation rates. The 20-year period of very low inflation that recently came to an end brought no positive leap forward in productivity nor any change in savings behaviour, except in reaction to the global financial crisis, points out Adam Posen of the Peterson Institute for International Economics, a think-tank in Washington.

If the costs of a slightly higher inflation target are small, the benefits are potentially sizeable. Chiefly, it could help central bankers avoid the so-called zero lower bound on nominal interest rates. Interest rates cannot go too far into negative territory, because they risk destabilising the banking system: depositors could always choose to empty their bank accounts and hold cash, which in effect carries an interest rate of zero, instead. That also limits the efficacy of negative interest rates. After the financial crisis some central banks set slightly negative rates on commercial banks’ reserves, but lenders had little ability to pass them on to their retail clients. The impotence of negative interest rates encouraged central banks to adopt unconventional policies, such as quantitative easing.

Higher inflation targets are a different solution to the problem of the lower bound. If the public expects the central bank to generate more inflation in future then the interest rate, in real terms, can still be sharply negative, stimulating the economy even without nominal interest rates needing to venture below zero. Allowing moderately higher inflation in normal times could therefore make it easier for the central bank to give a boost to the economy when trouble hits.

The opportunity to escape the lower bound on interest rates is no small thing. The current spell of monetary-policy tightening notwithstanding, the risk remains that interest rates will stay relatively low. The long-term factors that were weighing on interest rates before the pandemic, such as an ageing population and low productivity growth, are still in place. There may be a benefit in the short term, too, to raising targets now. Reducing stubbornly high inflation requires cooling the economy, which generally involves raising the unemployment rate. The lower the inflation target, the more unemployment central banks need to generate to get there. If the costs of inflation at 3% really are not much different from inflation at 2%, central banks will be generating additional unemployment for little benefit.

Seizing the inflationary moment

Set against this, however, are the consequences of reneging on a 30-year promise. The experience of the past year has made clear that the public detests inflation; both finance ministries and central banks are being excoriated for losing control of price growth. To shift the goalposts now could give the impression of giving up the fight entirely. Inflation targeting was meant to anchor the public’s expectations of price growth. Changing the target could undermine that objective altogether, by creating expectations that it will be raised again the next time inflation roars.

As long as inflation is so far off-target, such considerations seem likely to stay the hand of any would-be monetary reformers. Yet once it peaks, restoring a degree of central banks’ credibility, the pain of further disinflation, together with the promise of well and truly escaping the zero lower bound, could just start to make the idea of higher targets more alluring. ■

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Read more from Free Exchange, our column on economics:
Inflation shows both the value and limits of monetary-policy rules (Jul 14th)
Are central banks in emerging markets now less of a slave to the Fed? (Jul 9th)
The case for strong and silent central banks (Jun 30th)