In a recent press conference, US Federal Reserve (Fed) Chair Janet Yellen suggested the Fed was open to the idea of increasing its inflation target. The debate about the optimal inflation target has been simmering among academics for some time. Until now, however, the leadership of the Fed has been fairly dismissive of the need to reconsider its target. So Yellen’s call for more “research by economists that will help inform our future decisions” marks a significant moment. What is the case for a higher inflation target, and what are the costs to its implementation?
There is nothing particularly special about the 2% inflation target used by many central banks; it was chosen because of economists’ views at the time about the structure of the economy. So it seems perfectly sensible to consider whether 2% is still appropriate in light of lessons economists have drawn from the crisis. The most important of these lessons is that shocks that push interest rates towards zero – the zero lower bound - are more likely than was expected at the time, and this problem is likely to get worse in the future.
When interest rates are close to zero, central banks can struggle to provide further stimulus as interest rates can’t go much below zero because people can always hold cash rather than incurring the cost of a negative-yielding bank deposit. Central banks have used other tools such as quantitative easing and forward guidance to try to provide further stimulus when rates are at zero, but these are generally thought of as less reliable than interest rate cuts as they tend to have a less direct impact on financial conditions. So the economy gets stuck in a situation where it does not get as much stimulus as it needs, leading to lost output and higher unemployment.
The real rate is beyond the control of the central bank.
The risk of hitting the zero lower bound in part depends on the ‘normal’ level of interest rates - the level of rates expected to prevail when the economy is at full employment and inflation is at target. This “normal” level can be decomposed into the sum of the ‘real’ rate and the expected rate of inflation. The real rate is beyond the control of the central bank, determined by deep structural forces within the economy such as productivity, and generally tracks the trend growth rate of the economy. The expected rate of inflation should broadly correspond with the inflation target. If not, it could be a symptom that the country’s central bank lacks credibility.
When inflation targets were being introduced, it was widely assumed that the real rate was around 2%. With an inflation target of 2%, this should correspond with a ‘normal’ interest rate of around 4%. This gives the central bank 400 basis points (bps) of cutting space before rates hit the zero lower bound.
Many economists believe that the real rate has fallen since the financial crisis. The precise cause of this fall is up for debate, but likely contributors include demographics, inequality, the saving patterns of the emerging world, and the changing relative cost of capital goods. Many of these factors pre-date the crisis, so the real rate has probably been falling for some time, but the crisis seems to have accelerated the process. There is a wide range of estimates of how far the real rate has fallen, but 1% is a plausible estimate of the new level. If true, this means the ‘normal’ interest rate would now be 3%, leaving the central bank with only 300bps of cutting space in the event of a negative shock. So with an unchanged inflation target and a falling real rate, central banks are at greater risk of hitting the zero lower bound in future. Indeed, recent analysis suggests that with a 1% real rate and 2% inflation target, the Fed will hit the zero lower bound nearly 40% of the time.
The main benefit of a higher inflation target, therefore, is that it would offset the fall in the real rate. For example, with a 4% inflation target and 1% real rate, the central bank would have 500bps of cutting space. This would reduce the risk of hitting the zero lower bound, helping to avoid protracted periods of high unemployment and low growth while the central bank is effectively side-lined.
Higher inflation targets carry costs.
But alongside these benefits, higher inflation targets carry costs. Higher inflation has generally been associated with higher inflation volatility. Higher inflation volatility makes planning for the future much more difficult and would probably hurt investment and saving. Other costs of inflation tend to be quite subtle, undermining the efficiency of the economy. For example, by imposing a higher cost to money balances, causing prices to be updated more frequently, and potentially confusing price signals causing resource misallocation.
Another potential cost to increasing the inflation target is diminished central bank credibility. Central banks have invested significant effort into establishing the 2% target. Changing it could cause confusion in the short term, and reduce the credibility of the new inflation target as people worry it will be changed again in future. If the new target is not credible, there is less chance of the central bank hitting it as inflation expectations will not adjust appropriately. As a result, the benefit of moving to the higher target is lost.
It is also not obvious that a higher inflation target is the best response to the problem of the zero lower bound. An inflation target requires central banks to let bygones be bygones, in that failing to meet the target one year, has no implications for what the central bank should target in the next year. Another approach is for the central bank to target a price level, so that failure to meet the target price level one year implies the need to catch up with more inflation in the future. This arrangement may be better at providing the extra stimulus the economy needs when rates fall to zero, as it commits the central bank to keeping policy easy even as the economy recovers to make up for lost ground.
Overall, despite Yellen’s comments it is unlikely the Fed will adopt a higher inflation target anytime soon. However, the issue of how to deal with a lower “normal” interest rate, and the risk this creates of sustained periods of interest rates at the zero lower bound, is extremely pressing. So it is very welcome that the Fed is encouraging this debate, and it is important reminder that our current monetary arrangements are entirely contingent on the economic challenges we face, and likely to change over time.