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: Date: June 22, 2017 Topic: European Macroeconomics & Governance

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.

View comments
Read article More on this topic More by this author

Opinion

Can Eurozone Reform Help Contain Trump?

The Trump administration knows that a key source of US economic leverage is the dollar’s role as the world’s dominant reserve currency. Countering America’s disproportionate power to destabilize the global economy thus requires reducing the share of international trade conducted in dollars.

By: Jochen Andritzky Topic: Global Economics & Governance Date: October 17, 2018
Read article More on this topic More by this author

Blog Post

The international use of the euro: What can we learn from past examples of currency internationalisation?

The recent State of the Union speech by Jean-Claude Juncker sparked a discussion about the potential wider use of the euro on the international stage. Historically, it is not the first debate of this kind. Emmanuel Mourlon-Druol analyses four previous cases of debates on international currencies to reveal the different scenarios associated with their greater use, as well as the need to have a clear objective for a currency’s internationalisation.

By: Emmanuel Mourlon-Druol Topic: European Macroeconomics & Governance Date: October 15, 2018
Read about event More on this topic

Upcoming Event

Oct
23
12:30

Europe: Back to the future of a political project

This event will feature a discussion on different ideas for reforming European Governance.

Speakers: Ulrike Guerot, Adriaan Schout and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic

Blog Post

Improving the efficiency and legitimacy of the EU: A bottom-up approach

The 2019 European elections promise to be a watershed moment for the EU. A recent Bruegel paper made the case for restructuring the Union’s model of governance and integration. The authors of this post critically assess this proposed institutional engineering, and argue for the principle of “an ever closer union” to be safeguarded by a bottom-up approach to respond to the common needs of the citizens.

By: Silvia Merler, Simone Tagliapietra and Alessio Terzi Topic: European Macroeconomics & Governance Date: October 9, 2018
Read article More on this topic

Blog Post

Italy’s new fiscal plans: the options of the European Commission

The Italian government has announced an increase of its deficit for 2019, breaking the commitment from the previous government to decrease it to 0.8% next year. This blog post explores the options for the European Commission and the procedures prescribed by the European fiscal framework in this case.

By: Grégory Claeys and Antoine Mathieu Collin Topic: European Macroeconomics & Governance Date: October 8, 2018
Read article More on this topic More by this author

Podcast

Podcast

Director’s Cut: The Italian government budget proposal for 2019

Guntram Wolff welcomes Bruegel affiliate fellow Silvia Merler to evaluate the Italian government’s planned budget for 2019, in this Director’s Cut of ‘The Sound of Economics’

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: September 28, 2018
Read article Download PDF

Policy Contribution

European Parliament

Excess liquidity and bank lending risks in the euro area

In this Policy Contribution prepared for the European Parliament’s Committee on Economic and Monetary Affairs (ECON) as an input to the Monetary Dialogue, the authors clarify what excess liquidity is and argue that it is not a good indicator of whether banks’ have more incentives in risk-taking and look at indicators that might signal that bank lending in the euro area creates undue risks.

By: Zsolt Darvas and David Pichler Topic: European Macroeconomics & Governance, European Parliament, Testimonies Date: September 26, 2018
Read article More on this topic More by this author

Blog Post

Big Macs in big countries: an update on euro area adjustment

Have prices moved in the direction of correcting real exchange rate misalignments everywhere in the euro area in recent years? Not between the largest euro-area economies, i.e. France, Germany and Italy, says evidence from the Big Mac index. However, latest trends may be working in the right direction in these countries too.

By: Konstantinos Efstathiou Topic: Global Economics & Governance Date: September 20, 2018
Read article Download PDF More on this topic

Policy Brief

One size does not fit all: European integration by differentiation

The need for reform of the EU is increasingly urgent. The authors of this policy brief suggest a new governance model, combining a bare-bones EU with a 'Europe of clubs'. Such reform would offer scope for broad membership without stalling the process of integration for those that wish to pursue it.

By: Maria Demertzis, Jean Pisani-Ferry, André Sapir, Thomas Wieser and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: September 19, 2018
Read article More on this topic

Blog Post

The economic case for an expenditure rule in Europe

Proposals for reforming the euro area back on the agenda. An overhaul of the European fiscal rules should be on high on this agenda, because the current fiscal framework has not worked well. This column proposes substituting the numerous and complex present rules with a new, simple rule focused on limiting annual growth rate of expenditures.

By: Zsolt Darvas, Philippe Martin and Xavier Ragot Topic: European Macroeconomics & Governance Date: September 13, 2018
Read article Download PDF More on this topic

External Publication

The EU’s Multiannual Financial Framework and some implications for CESEE countries

Bruegel scholars Zsolt Darvas and Guntram Wolff contributed to the September 2018 edition of the OeNB's Focus on European Economic Integration.

By: Zsolt Darvas and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: September 12, 2018
Read article More on this topic More by this author

Opinion

Should central European EU members join the euro zone?

Eurozone membership (or the use of a fixed exchange rate) was not a factor determining economic success in Central Europe. There were both good and bad macroeconomic performances in both the flexible and the fixed exchange rate regimes of Central European countries. The implication is that Central European “outs” could be economically successful both with and without the euro, yet the EU is not only about economic benefits.

By: Zsolt Darvas Topic: European Macroeconomics & Governance Date: September 11, 2018
Load more posts