Raising the inflation target

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.