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

Blog Post

Building a stable european deposit insurance scheme

Deposit insurance, like any insurance scheme, raises moral hazard concerns. Such concerns arising from European deposit insurance can be alleviated through a country-specific component in the risk-based premium for deposit insurance and limits on sovereign bond exposures on bank balance sheets. This column argues, however, that proposals to maintain national compartments in a new European Deposit Insurance Scheme are self-defeating, as such compartments can be destabilising in times of crisis.

By: Dirk Schoenmaker Topic: Finance & Financial Regulation Date: April 19, 2018
Read about event More on this topic

Upcoming Event

Apr
25
12:30

Central banking in turbulent times

This event will look at fundamental questions about the central banking systems and how the Great Recession might have prompted a reassessment of the old central banking model.

Speakers: Maria Demertzis, Paul De Grauwe, Marianne Nessén and Francesco Papadia Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic More by this author

Blog Post

The debate on euro-area reform

A paper jointly written by 14 French and German economists set off a debate about the reform of euro-area macroeconomic governance. We review economists’ opinions about it.

By: Silvia Merler Topic: Finance & Financial Regulation Date: April 16, 2018
Read article More on this topic More by this author

Blog Post

Latvia’s money laundering scandal

Latvia’s third largest bank ABLV sought emergency liquidity from the ECB and eventually voted to start a process of voluntary liquidation, after being accused by US authorities of large-scale money laundering and having failed to produce a survival plan. What does it mean for the ECB?

By: Silvia Merler Topic: Finance & Financial Regulation Date: April 9, 2018
Read article More on this topic More by this author

Opinion

The Lesser Evil for the Eurozone

For three decades, the consensus within the European Commission and the European Central Bank on the need for market reforms and sound public finances has been strong enough to overcome opposition in small countries and outlast procrastination in large ones. Today, however, the Eurozone playing field has become a battleground.

By: Jean Pisani-Ferry Topic: Finance & Financial Regulation Date: April 4, 2018
Read article Download PDF More by this author

External Publication

European Parliament

Cash outflows in crisis scenarios: do liquidity requirements and reporting obligations give the SRB sufficient time to react?

Bank failures have multiple causes though they are typically precipitated by a rapidly unfolding funding crisis. The European Union’s new prudential liquidity requirements offer some safeguards against risky funding models, but will not prevent such scenarios. The speed of events seen in the 2017 resolution of a Spanish bank offers a number of lessons for the further strengthening of the resolution framework within the euro area, in particular in terms of inter-agency coordination, the use of payments moratoria and funding of the resolution process.

By: Alexander Lehmann Topic: European Parliament, Finance & Financial Regulation, Testimonies Date: March 28, 2018
Read article More on this topic

Blog Post

Do wide-reaching reform programmes foster growth?

With growth gathering momentum in the eurozone, some have claimed this is the proof that structural reforms implemented during the crisis are working, re-opening the long-standing debate on the extent to which reforms contribute to fostering long-term growth. This column employs a novel empirical approach – a modified version of the Synthetic Control Method – to estimate the impact of large reform waves implemented in the past 40 years worldwide.

By: Alessio Terzi and Pasquale Marco Marrazzo Topic: European Macroeconomics & Governance Date: March 28, 2018
Read article More on this topic More by this author

Opinion

Europe needs a strong Italy

Europe needs to have its Italian voice. A stable government is required not only to pursue domestic policies and remain fiscally prudent but also to negotiate on euro-area reform, priorities in the EU budget and intensifying competition in global trade.

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: March 20, 2018
Read article More on this topic More by this author

Blog Post

Central banks in the age of populism

Two years of elections have shown that we live in an age of increasing political and economic populism. What are the consequences of that for central banks? We explore opinions about it, from both 2017 and more recently.

By: Silvia Merler Topic: Finance & Financial Regulation Date: March 19, 2018
Read article

Blog Post

Breaking the Stalemate on European Deposit Insurance

Many EU-level reports have highlighted a European Deposit Insurance Scheme (EDIS) as a necessary component of banking union, but none of these options has met sufficient consensus among euro-area countries. The authors of this blog propose to end the deadlock with an EDIS design that is institutionally integrated but financed in a way that is differentiated across countries.

By: Isabel Schnabel and Nicolas Véron Topic: European Macroeconomics & Governance, Finance & Financial Regulation Date: March 5, 2018
Read article More on this topic More by this author

Podcast

Podcast

Euro-area governance: Where next?

Bruegel deputy director Maria Demertzis hosts this episode of 'The Sound of Economics', with Gideon Rachman, chief foreign affairs correspondent at the Financial Times, and Manfred Weber, chair of the EPP Group in the European Parliament, joining Bruegel director Guntram Wolff for a discussion of the future of euro-area governance.

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: March 1, 2018
Read article More on this topic

Blog Post

Don’t put the blame on me: How different countries blamed different actors for the Eurozone crisis

Why did the eurozone have such difficulties coming to terms with its own shortcomings? The authors believe they have found part of the answer, through an algorithm-based cross-country media analysis.

By: Henrik Müller, Giuseppe Porcaro and Gerret von Nordheim Topic: European Macroeconomics & Governance Date: March 1, 2018
Load more posts