Central banks have long stuck to the 2 per cent inflation target but now the conventional wisdom is being questionedby David Wessel / July 5, 2018 / Leave a comment
The Bank of England. Photo: Stefan Rousseau/PA Wire/PA Images About a quarter century ago, central bankers around the world coalesced around a monetary policy strategy that was elegant in its simplicity. Although details vary, the world’s major central banks said they would aim to move interest rates to keep inflation at around 2 per cent. The theory was that setting such a target would promote economic stability and anchor public inflation expectations so that the central banks could, when necessary, tolerate a little more or a little less inflation without unsettling consumers, businesses or investors. It was, the International Monetary Fund has said, “a pragmatic response to the failure of other monetary policy regimes.” New Zealand and Canada moved first. The Bank of England followed in 1992, and the European Central Bank did so in its infancy in 1998. Policymakers at the United States Federal Reserveprivately agreed to an inflation target of 2 per cent in 1996, but didn’t make it official—and public—until 2012. Inflation targeting at around 2 per cent worked reasonably well for a while. It was easy to communicate. It gave the public and politicians a yardstick against which to measure central bank performance. It helped bring inflation down around the world. Today the wisdom of sticking to the 2 per cent inflation target is being questioned. With so much invested in the 2 per cent target no central bank is likely to move quickly to alter or replace it. But calls to rethink it have been proliferating, both from inside and outside the central banks, largely because of concerns that the current framework will make it uncomfortably difficult for central banks to fight the next recession. What changed? First, when central banks adopted the 2 per cent target, few central bankers—many of them veterans of campaigns to reduce inflation—anticipated that they would find themselves following the Japanese into an inflationary trough, an extended period in which they couldn’t get inflation up to 2 per cent. The inability (until very recently) to get inflation up to 2 per cent threatened the credibility of the whole regime. The UK is an exception, but few other central banks want to generate inflation by watching their governments embrace a policy (Brexit) that leads to a sharp depreciation in its currency, which tends to push up prices. Second, the global financial crisis and ensuing Great Recession reminded everyone that focusing exclusively on price inflation is not sufficient to keep economies healthy. The ECB’s rate hike of June 2007—a mistake in retrospect—and its reluctance to cut rates until the fall 2008 are evidence of that. “The current framework could make it difficult for central banks to fight the next recession” Third, and most important, is the consensus that the real (or inflation-adjusted) neutral rate of interest that is likely to prevail in the long run is lower than it has been historically. In the early 2000s, economists at the Fed and elsewhere estimated this rate at around 3 per cent. With 2 per cent inflation and a 3 per cent neutral rate, nominal rates would hover around 5 per cent when all was calm. That would give the Fed room to cut rates by 4 or 5 percentage points as it often does in recession. The latest projections of the long-run neutral real rate are much lower, perhaps 1 per cent or even less. The median forecast of Fed policymakers is that nominal rates will be around 2.9 per cent in the long-run; since cutting rates much below zero is nearly impossible, this could limit the Fed’s ability to fight the next recession with conventional interest rate cuts. Of course, central bankers have a variety of unconventional policy tools—the massive purchases of long-term assets known as “quantitative easing,” the promises about keeping interest rates low known as “forward guidance”—but it’s not clear how willing they will be to deploy them again or how effective they will be. Hence the talk of altering or replacing the 2 per cent inflation target. “Even if 2 per cent was exactly the right number based on what we knew in 2006 it cannot be the right number today,” says former chief IMF economist Olivier Blanchard, now at the Peterson Institute for International Economics. What are the options? The alternative Blanchard favors is to simply raise the target to 3 per cent or 4 per cent, which would give central bankers more maneuvering room. Some central bankers wince at this, arguing that a higher target might not fit their legal mandate of “price stability” or that raising the target would undermine their credibility and make their jobs tougher. Central banks also could target something other than the inflation rate. One leading alternative is to target the price level. An inflation-targeting central bank lets bygones be bygones; it aims at getting inflation to 2 per cent in the future, and doesn’t compensate for long period of below- or above-target inflation. With a price-level target, a central bank that weathered a long period of below-target inflation would keep rates low for a long time to achieve a period of above-target inflation. Or a central bank could target the growth of nominal (that is, before adjusting for inflation) gross domestic product. For a central bank like the Fed, whose mandate is maximum sustainable employment and price stability, this would combine both objectives in one measure. The Fed would cut interest rates when nominal GDP was below target whether that was because inflation was too low or unemployment too high; it would raise rates when nominal GDP was above target whether that was because inflation was too high or unemployment was unsustainability low. (For a more detailed discussion of the alternatives, see “Rethinking the Fed’s 2 per cent inflation target,” a report by the Brookings Institution’s Hutchins Center on Fiscal and Monetary Policy.) Central bankers embraced the 2 per cent inflation target only after years of contemplation and ground work by academic economists. It’ll probably take several years before they tweak it or abandon it. Let’s hope the next recession doesn’t arrive before they figure out what to do.