The ill-advised rigidity of the 2% inflation target
Our macroeconomic policy is largely based on the theory mainly developed in the post-war years, and more particularly at the time of the Great Moderation. This was the period of steady, reasonably predictable economic growth from the beginning of the 1980s until the crisis of 2007/2008 and the subsequent Great Recession. As a result of the financial crisis and its aftermath, much of this macroeconomic consensus has come under fire. This also applies to the inflation target set by the central banks (Blanchard et al, 2010). So far the ECB has chosen to ignore this and the 2% inflation target remains sacrosanct, even though anyone with any knowledge of the history of monetary policy is well aware that this target has a very flimsy empirical foundation. Continuing to target 2% inflation has now become ill-advised and dogmatic, and is making the process of adjustment in the eurozone unnecessarily lengthy and painful.
Inflation as price stability
The explicit target of the European Central Bank (ECB) is price stability. In practice, price stability is interpreted to mean “medium-term inflation of less than, but close to 2%”. Inflation is currently falling, and the average rate in the eurozone is now close to zero, having reached 0.5% in May 2014 (figure 1).
Furthermore, it looks highly likely that inflation will remain low in the next few years (Claeys et al., 2014) as a result of the moderate growth outlook and the negative output gap in nearly all the eurozone countries.
With this in mind, one could argue that discussion of the ECB’s inflation target is perhaps not that relevant. After all, the current target is not even being met. But it is relevant, for two reasons at least: firstly, raising inflation expectations by adjusting the target would increase inflation over time. Secondly, this would give the ECB a clearer mandate in the near future to deploy unconventional policy measures in order to increase inflation faster over time.
At first sight, it might seem strange that in the opinion of central bankers price stability implies a continuous increase in prices. Because both inflation and deflation can be experienced as ‘unfair’. Either a rise or a fall in the average level of prices will lead to a redistribution of real assets and incomes. A steady rise in the average price level undermines the value of existing assets, especially if these assets generate a fixed income. These assets increase in value if prices fall. The same applies to debts: inflation erodes their value, and deflation increases their value in real terms.
In addition to price stability, since the outbreak of the crisis the Western central banks have mainly concentrated on keeping the financial system intact. It is also now clear that despite price stability as measured by consumer prices (HICP in the eurozone), the prices of property and financial assets require extra attention. These prices are not included in the consumer price index, even though their huge rises and corresponding falls in recent years have certainly had a significant effect on the real economy. This is why the central banks in all countries are focusing even more on macroeconomic stability with macro-prudential policy.
The importance of stability in price increases
The seemingly contradictary notion that ‘price stability’ is operationalised as a small amount of inflation can easily be defended. Firstly, price stability primarily means that prices develop predictably and without volatility. Stable and predictable price development leads to the best growth performance. It does not matter that much whether there is an average increase in prices or prices are stable; it is large fluctuations that cause significant (and expensive) processes of adjustment (Mishkin, 2011). An independent and reliable central bank with a clear mandate can make a strong contribution here.
Secondly, deflation is generally considered to be a much more disastrous phenomenon than a small amount of inflation. In this case, it is not really the actual price development that is important, it is the effect on inflation expectations. While evidence for this is hard to come by, the fact remains that if goods and services will be cheaper tomorrow people will probably defer their purchases or investments. The situation in the Dutch housing market in recent years is a good example. If expectations of deflation are anchored in a period in which high debts were built up, this creates a debt-deflation spiral that can be hard to escape. These days, this is often referred to as a ‘Japan scenario’, however the phenomenon was already well known in the 1930s (Fisher, 1933). With this in mind, striving for a small amount of inflation is a safer option. This is the explicit reason stated on the Fed's website, and it is hinted at by the ECB as well.
Thirdly, in connection with this and much more important at this time, high inflation could be reined in relatively easily by raising interest rates. But this would have an economic price – it would take the heat out of the economy. Dealing with deflation is more difficult, as the experience over the last twenty years in Japan has shown. Negative nominal interest rates cannot be achieved, or only with great difficulty. This is known as the zero interest problem, or the zero lower bound. If it becomes more attractive for people to keep their money in an old sock without a return rather than take it to the bank, which will cost them money in case of negative interest rates, the financial sector and therefore also the economy will have a big problem. This problem is known as the liquidity trap, and for a long time has been seen as only a theoretical possibility. Monetary policy is extremely difficult in this situation, and austerity policies when real interest rates are too high would cause additional damage (Blanchard and Leigh, 2013). A further problem is that real interest rates would continue to rise if deflation continued, depressing economic activity further. In the Western world in recent years, it has become apparent that this is not just a theoretical problem. The best interest-rate response given falling activity was not available due to the zero lower bound problem. This supports that argument that inflation should be slightly higher than 0%, since it makes a fall to the lower limit less likely and leaves more room for monetary policy.
The fourth point is that the official statistics could very probably be overestimating the actual development of prices. See for example the Boskin report published nearly 20 years ago. And despite the fact that many of this report’s recommendations have now been adopted and so-called hedonic prices are calculated, it is still difficult to reflect quality improvements in the price statistics.
Fifthly, money illusion leads to nominal downward price rigidity. In Europe’s case this may be more important than the zero lower bound. Simply put, money illusion refers to the fact that people tend to think in nominal amounts and do not take account of inflation. A small average price increase means that nominal price rigidities are less painful, so that relative real adjustments to wages in the labour market are easier to implement and unemployment falls. It greases the wheels of the economy, as James Tobin put it in 1972.
Nominal downward price rigidities may or may not exist in the post-Friedman theoretical neo-classical world, but they certainly have an effect in real life. We see this mainly in the labour market, where a nominal cut in wages for employees is always front page news. We see it in mortgage loans as well, which are also expressed in nominal terms. Economists like Fisher, Keynes, Tobin, Solow, Samuelson, Akerlof and Shiller have all pointed to the existence of money illusion. On this basis, it would seem to be clear that an inflation target of well above zero is advisable. The interpretation of ‘well above zero’ as the 2% level currently being used is not based on strong empirical grounds (Krugman, 2014). It is mainly the result of a policy consensus reached in the 1990s, thus during the period of the Great Moderation, and it worked fairly well during that time. But times have changed, and the 2% inflation target is causing problems both now and for the future.
2% is too low
So it can be argued that a small amount of inflation is justified in terms of price stability. But does this have to be the 2% level used by the ECB? There are several objections to such a rigid target, especially in the eurozone.
First of all, monetary policy throughout the Western world has been at the zero lower bound for some considerable time. If the inflation target had been higher, this limit would not have been reached so soon. Raising the inflation target would also raise expectations of inflation.
The zero lower bound makes the interest-rate as a tool of monetary policy more or less ineffective. A simple Taylor rule for the various countries in the eurozone shows that the real interest rate is still much too high, particularly in Southern Europe (figure 2).
The IMF (IMF, 2014) expects real interest rates to remain low for some years, meaning that at this level of inflation the zero lower bound problem will be encountered sooner and more frequently. Both demand (lower investment in the West) and supply (higher savings) play a part in this forecast. This is an argument for higher inflation (Ball, 2013), especially since effective unconventional policy appears to be problematic at all times. After all, there are good reasons for calling it unconventional policy.
Secondly, the current level of inflation and the related inflation target mean that the economy of the eurozone as a whole is adjusting more slowly than necessary. In recent years, there has not been such a test of the effects of nominal rigidities since the introduction of the 2% inflation target. If the markets were to operate flexibly, with average unemployment of 12% deflation would be a more likely expectation in the eurozone countries. The fact that this has not happened may be the result of successful policy, and the fact that inflation expectations have been fixed as a result, as the IMF concluded in its analysis last year (IMF, 2013). However this could be very much due to the effect of nominal rigidities, as Paul Krugman has also previously suggested. In the eurozone, nominal wages declined only in Ireland and Greece between 2008 and 2013 (figure 3). Given the size of the output gap and the level of unemployment, this is quite logical, even though the changes have been only minimal. It is only the change in real terms that has been negative in a greater number of countries. However this change too has been very limited (see figure 3).
Research by the ECB also shows the existence of this type of money illusion (Babecky et al., 2009). Effective policy by the ECB for the real economy should therefore consist precisely of further monetary easing, so that nominal rigidities have less effect.
A country such as Greece is now clearly in a debt-deflation spiral (it is currently the only eurozone country experiencing deflation), while Spain, Portugal and Ireland are very close to this. Lower wages and prices only make the repayment of nominal debts more difficult. For these countries, low inflation therefore makes the process of adjustment more painful and longer lasting than it needs to be.
There is however another challenge facing the eurozone. Germany, the ‘anchor’ of the eurozone, does not need higher inflation. Based on the Taylor rule, the policy interest rate for Germany should be significantly higher than for Greece, for example (figure 4). A single monetary policy for countries that are in different stages of development is extremely difficult. However a higher inflation rate would accelerate the process of adjustment and achieve convergence within the eurozone more quickly. This would also mean that imbalances (or ‘bubbles’) in countries where interest rates are currently too low, such as Germany and Austria, would have less time to materialise.
Targeting a rate of inflation of say 4% could ameliorate the problems described above, especially since there is a limit to what the ECB can achieve with further monetary easing. As Krugman put it, a “credible promise to be irresponsible” can lead to an increase in inflation expectations. This would lead to more possibilities for effective monetary policy and a faster adjustment to prices in real terms, which would in turn mean that convergence within the eurozone could happen more quickly.
But nothing changes
A higher inflation target is very desirable, since the zero lower bound problem is not going to go away in the coming years and the desired real adjustment between the various economies in the eurozone is significant in historical terms.
But there is much resistance to this idea. The main argument of many central bankers is that the current inflation target does not conflict with a consistent monetary policy (Mishkin, 2011). Indeed they claim the biggest success of the current policy is that it is predictable and credible. If the inflation target were to be suddenly changed in response to the economic situation, this could be perceived as inconsistent. I take a different view. If 2% is a credible target, 3% is a credible target too. Or 4%. After all, much has changed in the macroeconomic environment. Unfortunately for the central banks, the success of the policy of price stability in many Western countries since the end of the 1980s cannot be attributed only to the central banks pursuing an inflation target of 2%.
A different macroeconomic environment, in which the zero lower bound problem and nominal rigidities are major concerns, may also require a different kind of monetary policy. It is certainly arguable that an upward adjustment to the inflation target is needed, given the two problems outlined above. And if citizens are really rational, they will understand this.
Furthermore, inflation of above 2% is not necessarily bad for stability and growth and doesn’t automatically mean that inflation expectations will run wild. Until 20 years ago, such a policy was actually quite normal in terms of an inflation target. It is only when inflation goes above 10% that there is some evidence of adverse effects on growth and stability (Ball, 2013).
But there is another problem that is totally unrelated to monetary policy that makes a higher inflation target politically impossible: a higher inflation target means that debts would erode and assets would be worth less. And this exactly coincides with the division between high unemployment and low unemployment countries in the eurozone.
Babecky, J., P. Du Caju, T. Kosma, M. Lawless, J. Messina en T. Rõõm (2009). Downward Nominal and Real Wage Rigidity : Survey Evidence from European Firms. Working Paper no. 1105. ECB: Frankfurt.
Ball, R. (2013). The Case for Four Percent Inflation. Central Bank Review, Vol. 13, pp. 17-31.
Blanchard, O., G. Dell’Ariccia and P. Mauro (2010). Rethinking Macroeconomic Policy, IMF Staff Position Note SPN10/03. IMF: Washington.
Blanchard. O. and D. Leigh (2013). Growth Forecast Errors and Fiscal Multipliers, IMF Working Paper WP13/01. IMF: Washington.
Claeys, G., P. Hüttl and S. Merler (2014). Is there a risk of deflation in the euro area? Blog Bruegel.org 3 April 2014.
IMF (2013). World Economic Outlook April 2013. Ch. 3: The dog that didn’t bark: Has Inflation been Muzzled or was it just Sleeping? IMF: Washington.
IMF (2014). World Economic Outlook April 2014. Ch. 3: Perspectives on Global Real Interest Rates. IMF: Washington.
Krugman, P. (2014). Inflation Targets Reconsidered. Draft paper for ECB Sintra conference, May 2014.
Mishkin, F. (2011). Monetary Policy Strategy: Lessons from the Crisis. NBER Working Paper 16755 NBER: Cambridge, MA.