Blog Post

Raising the inflation target: a question of robustness

In an unexpected move, the Federal Reserve Chair Janet Yellen has recently brought up the issue of raising the inflation target. This blog argues that an increase in inflation targets may prove to be beneficial in achieving price stability in the long run. This would increase the credibility of central banks in achieving inflation goals and stave off the distortionary effects of deflation.

By: and Date: June 22, 2017 Topic: Macroeconomic policy

The discussion on raising the inflation target to 4% has just gotten a new impetus after the Fed Chair, Janet Yellen, urged in a recent press conference to rethink the issue. Ms Yellen, asked for more research to be done to understand what this would achieve.

Since there is some evidence that euro-area monetary policy eventually follows US monetary policy, we perhaps need to have this discussion in the euro area as well.

In my view, there are three questions that we need to ask in order to understand what a higher inflation target would offer and also what the risks would be.

Does aiming for higher inflation avoid periods of disinflation more effectively? In my view, it does. This is the main argument put forward by Olivier Blanchard and co-authors, and reiterated by Janet Yellen. Having an inflation target at a slightly higher level would provide greater space for the interest rate to move before landing on the zero-lower bound, where it ceases to function. If the costs of falling prices are very high, then we must avoid the problem by overshooting in the other direction.

Is the objective of price stability better served by setting a higher target? Price stability is identified by an inflation rate below but close to 2%. By exploring the merits of increasing the target to 4%, I do not argue that the definition of price stability has changed; I just explore whether a higher target would avoid periods of very low inflation more effectively. What follows naturally in the argument, in my view, is that the inflation objective of 2% cannot be achieved in the policy horizon but has to be considered as an average over a longer period.

But there are important issues to consider here that relate to the possibility of implementing such a target. The success of revealing an inflation target is that it helps anchor expectations and thus build credibility. But, importantly, that target should also be consistent with price stability. Can we really talk about credibly committing to an inflation rate other than what is consistent with price stability? Doesn’t that risk de-anchoring expectations, eliminating the benefits of inflation targeting, and effectively jeopardising the central bank’s ability to control inflation?

The variety of national experiences in the way they have adopted an inflation targeting regime is quite illustrative in this respect (figure 1). Some countries that have had to bring inflation down from very high levels (Poland, Chile, Israel, Mexico and to lesser extent Canada and New Zealand) adopted inflation targeting in a step-wise manner. This meant changing the target (and the width of the tolerance band around it) in small consecutive steps. This was a way of making small but very concrete progress by demonstrating that they can indeed control inflation. Each time inflation fell, respective Central Banks reduced the target further, building up credibility along the way. I explain here in detail the mechanism of how this happens. Other countries (Australia, Sweden, UK and Norway) instead preferred to reduce inflation to the level consistent with price stability, before adopting (a)n (low) inflation targeting regime

Figure 1: Inflation, long-term expectations where available and tolerance bands

Sources: Consensus forecasts and Central Bank sites

In my view, both approaches can work. It is a matter of communicating effectively what the new objective would aim to achieve. If this objective in the euro area is communicated as an effort to avoid very distortionary outcomes, then markets can learn to adapt to the new framework. Communication could then take the following form: while the objective of monetary policy is still to achieve 2% inflation, it will be assessed as an average over longer periods of time, not over the 2-year horizon as is currently. Aiming for 4% in the 2-year horizon, the argument goes, would help achieve 2% in the longer run.

So, if putting up with a higher inflation rate in “normal times” is sufficient to ensure avoiding the zero-lower bound, then, yes, the objective of price stability is better served. The target simply becomes an instrument for managing uncertainty in the medium term. And it is a more robust method as it avoids very distortionary outcomes more effectively. The remaining question then is how to decide by how much to increase the target. Is 4% sufficient, and in what sense can we talk about sufficiency? One answer provided in this respect is by moving away from “optimal” outcomes to a “good enough” outcome. Defining “good enough” is then very important. Concretely, policy makers would have to define the highest level of inflation that they would be prepared to tolerate as an objective in good times.

Can we manage the transition? There are important reasons why this might be difficult, the most obvious one being how to get to 4%. With the zero-lower bound difficult to escape from and core prices persistently low, what types of policies could realistically bring the system to this higher level of inflation, when even 2% is proving so difficult to attain? What size would QE have to take and could this harm banks and the financial system?

This difficulty becomes even more pertinent if one believes that the euro area economy is slowly moving into “secular stagnation”. If the new normal does involve lower levels of growth and interest rates, then a higher inflation rate may be difficult to justify. My view on the latter point is that so long as levels of debt (private and fiscal) remain as high as they are in the euro area, we should not attempt to answer this question. We shouldn’t therefore draw conclusions before the financial system becomes capable of generating credit that is convincing for sustainable growth.

Lastly, it is legitimate to ask whether the ECB, coming out of a very difficult 10-year period and still relying on unconventional instruments to perform its tasks, has sufficient standing to afford to change the “terms of the contract” it has signed with its “principal”.

Conclusions

While changing the inflation target involves risks and can run into important transitional difficulties, we must give sufficient consideration to the fact that we need to rethink how to best pursue price stability. The most important aspect that I believe we should introduce is a framework for thinking about uncertainty and how to manage it. It is the only way of creating robust systems. I welcome the suggestion of increasing the target as a way of avoiding the very distortionary effects of deflation, irrespective of how likely we are to witness disinflation in the future. It remains to be seen by exactly how much we should increase the target and I would welcome discussions on the issue.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

Read article
 

Blog Post

European governance

Including home-ownership costs in the inflation indicator is not just a technical issue

The European Central Bank is right to propose inclusion of owner-occupied housing services in the inflation indicator. But the ECB’s preferred method would involve an asset price in the consumer inflation indicator.

By: Zsolt Darvas and Catarina Martins Topic: European governance, Macroeconomic policy Date: November 18, 2021
Read article More by this author
 

Blog Post

Fiscal arithmetic and risk of sovereign insolvency

The record-high debt levels in advanced economies increase the risk of sovereign insolvency. Governments should start fiscal consolidation soon in an environment of low nominal and real interest rates and post-COVID growth.

By: Marek Dabrowski Topic: Global economy and trade, Macroeconomic policy Date: November 18, 2021
Read article Download PDF More by this author
 

Parliamentary Testimony

European governanceEuropean Parliament

The New Euro Area Inflation Indicator and Target: The Right Reset?

Testimony to the Monetary Dialogue Preparatory Meeting of the European Parliament's Committee on Economic and Monetary Affairs (ECON).

By: Zsolt Darvas Topic: European governance, European Parliament, Macroeconomic policy Date: November 9, 2021
Read article
 

External Publication

European governanceEuropean Parliament

The new euro area inflation indicator and target: the right reset?

In-depth analysis on the European Central Bank's revised inflation target prepared for the European Parliament's Committee on Economic and Monetary Affairs (ECON).

By: Zsolt Darvas and Catarina Martins Topic: European governance, European Parliament, Macroeconomic policy Date: November 4, 2021
Read about event More on this topic
 

Past Event

Past Event

European monetary policy: lessons from the past two decades

This event will feature the presentation of “Monetary Policy in Times of Crisis – A Tale of Two Decades of the European Central Bank."

Speakers: Petra Geraats, Wolfgang Lemke, Francesco Papadia and Massimo Rostagno Topic: Macroeconomic policy Date: November 4, 2021
Read article Download PDF More on this topic
 

Working Paper

Does money growth tell us anything about inflation?

Attention should be paid to a possible sequence of negative events: if inflation would start to be volatile and money growth remains high, efforts to control inflation could be undermined.

By: Leonardo Cadamuro and Francesco Papadia Topic: Macroeconomic policy Date: November 4, 2021
Read article
 

Blog Post

European governance

Is the risk of stagflation real?

Most economic forecasts predict a return, in the medium-term, to pre-pandemic growth and inflation. Nevertheless, the European Central Bank and fiscal authorities need to be vigilant for signs of the contrary.

By: Monika Grzegorczyk, Francesco Papadia and Pauline Weil Topic: European governance, Macroeconomic policy Date: November 2, 2021
Read about event
 

Past Event

Past Event

Microchips and Europe's strategic autonomy

Per microchips ad strategic autonomy.

Speakers: Piotr Arak, Alicia García-Herrero, Jay Lewis, Stefan Mengel and Niclas Poitiers Topic: Digital economy and innovation, European governance Date: November 2, 2021
Read article More by this author
 

Opinion

European governance

Is the ECB right to take on climate change?

The real issue here is not that the ECB takes a very sizeable risk by pursuing climate objectives but rather, that it cannot afford not to. And by doing so, it helps establish just how urgent climate change is.

By: Maria Demertzis Topic: European governance, Green economy, Macroeconomic policy Date: November 2, 2021
Read article
 

Blog Post

European governance

Germany’s post-pandemic current account surplus

The pandemic has increased the net lending position of the German corporate sector. By incentivising private investment, policymakers could trigger a virtuous cycle of increasing wages, decreasing corporate net lending, which would eventually lead to a reduction of the economy-wide current account surplus.

By: Lionel Guetta-Jeanrenaud and Guntram B. Wolff Topic: European governance, Macroeconomic policy Date: October 21, 2021
Read about event
 

Past Event

Past Event

Monetary policy in the time of climate change

How does climate change influence monetary policy in the eurozone? What potential monetary policy measures should be taken up to address climate risks?

Speakers: Cornelia Holthausen, Jean Pisani-Ferry and Guntram B. Wolff Topic: Green economy, Macroeconomic policy Date: October 20, 2021
Read article
 

External Publication

European Parliament

Tailoring prudential policy to bank size: the application of proportionality in the US and euro area

In-depth analysis prepared for the European Parliament's Committee on Economic and Monetary Affairs (ECON).

By: Alexander Lehmann and Nicolas Véron Topic: Banking and capital markets, European Parliament, Macroeconomic policy Date: October 14, 2021
Load more posts