The argument for a
higher inflation target is straightforward, once you understand two
things. First the most effective and reliable monetary policy
instrument is to influence the real interest rate in the economy,
which is the nominal interest rate less expected inflation. Second
nominal short term interest rates have a floor near zero (the Zero
Lower Bound, or ZLB). Combine the two and you have a severe problem
in a recession, because to combat the recession real interest rates
need to move into negative territory, and how far they can go into
that territory is limited by the ZLB. That means monetary policy
alone may be unable to get us out of a recession.
Raising the
inflation target reduces the likelihood that interest rates will hit
the ZLB. To see why, note first that the long run (economists often
say ‘equilibrium’ or ‘natural’) real interest rate is
positive. Let’s say it is 2%. If the inflation target is 2%, and
the ZLB is 0%, that would mean that in normal times the average nominal interest
rate is 4% (2% inflation target + 2% to get to a 2% real interest
rate). That means nominal interest rates can be cut by a maximum of
4% if the economy falters. That may be enough for a mild downturn,
but as we saw in 2008 it is not enough for a major recession. However
if the inflation target was 4%, nominal rates would now be able to
fall by a maximum of 6%. That is probably enough to combat all but
the worst kind of recession.
Why are many
economists currently arguing that we should raise the inflation
target from 2% to 4%? One of the reasons is that we now believe the
long run real interest rate is currently lower than it was when the
2% target was first chosen. (This is sometimes referred to as secular
stagnation.) If you go through the arithmetic above, you can see why
a lower long run real interest rate will make the ZLB problem worse.
The argument is that we now need to raise the inflation target to
make sure we hit the ZLB less often in the future.
This issue moved
from an academic discussion to a real possibility in the US a few
days ago. When Fed Chair Janet Yellen had been asked about raising
the inflation target in the past, she has tended to dismiss the idea.
However she now says
that it is something that the Fed will review in the future, and that
it is one of the most important questions facing central bankers
today.
This will
undoubtedly give new impetus to the debate over whether the inflation
target should be raised. We are in standard trade-off territory here.
Economists generally agree a higher inflation target will in itself
inflict greater costs on the economy, but they bring the benefit that
the ZLB problem will occur less often. But there is an alternative,
and clearly much better way out of this dilemma.
Governments have
another instrument that has a reasonably predictable impact on
aggregate demand, and which can be used to combat a recession: fiscal
policy (changes to taxes and government spending). In the UK at the moment interest rates are at the ZLB in part
because fiscal policy is contractionary (austerity). It would be far
better to use this instrument to stimulate the economy in a recession
than to raise the inflation target. Yet the institution of
independent central banks have discouraged governments from using
fiscal policy in this way.
It is no good
central banks pretending that this is something which is up to
governments, and that there is some unwritten law which means that
central banks should keep quiet on such things. In reality, in both
the UK and the Eurozone, the central bank actively encouraged
governments to do the wrong thing with fiscal policy in the last
recession. In other words, they encouraged austerity. If there is
something inherent in the institution of a central bank that makes
them give inappropriate advice in this way, then we should be asking
how central banks can be changed as a matter of urgency.
What should happen
in a recession, as soon as the central bank thinks that interest
rates will hit the ZLB, is that central banks should say, out loud in
public, that fiscal policy should become more expansionary. In
addition central banks should say, out loud in public, that
governments need not worry about rising debt and deficits due to the
recession and any fiscal stimulus they undertake spooking markets because the central
bank has that covered. Both statements have the merit of being true.
Of course governments will need to restore debt to desired levels at some point, but that point should be well after interest rates have left the ZLB because then debt correction can be painless. The immediate aim of fiscal policy in a recession should be to allow
interest rates to rise above the ZLB as soon as possible. That gives you the best
macroeconomic outcome, and one that is far superior to raising the
inflation target. The most important question facing central bankers
today is why they failed to do that from 2009.
Now it is possible
that, if democracy is in a bad shape (as it currently is in the US
for example), the government may ignore the advice it receives from
the central bank. In that case it is worth considering giving central
banks some additional power to mimic a fiscal expansion, such as
helicopter money for example. Or it may be worth considering
institutional changes that allow nominal interest rates to go
negative. Or raising the inflation target. But before doing any of
those things we need to ensure that central banks give the right
advice to governments when the next recession comes along.
