By Tom Fairless
What's so special about 2% inflation?
From Ottawa to Oslo, policy makers have been considering whether
that level of consumer-price growth, a Holy Grail for the world's
major central banks over the past quarter-century, is still
relevant.
The 2% target was always an arbitrary figure, some economists
argue, and even if it was optimal two decades ago, that is no
longer the case given deep changes that have since reshaped the
global economy.
Trouble is, it isn't clear what inflation rate would be better.
Dozens of academic studies that considered that question have
produced answers ranging from 6% to less than zero, according to a
survey published last year by Federal Reserve economist Anthony M.
Diercks. While deflation, or steadily falling prices, are generally
considered to weigh on economic growth, a mildly negative inflation
rate would also have benefits, such as eliminating the cost of
holding cash.
The debate has gained traction since former Federal Reserve
Chairwoman Janet Yellen suggested last year that the U.S. central
bank might revisit its 2% inflation target. Canadian officials have
also suggested they might be open to changing the Bank of Canada's
2% target when its mandate comes up for review in 2021.
Recently, economists have tended to call for a higher target.
The main argument: That would give central banks more room to fight
economic downturns because higher inflation implies higher interest
rates, thus giving the Fed more room to cut.
"Whatever [inflation] rate was thought to be optimal in 2006 or
before is now too low," says Olivier Blanchard, a senior fellow at
the Peterson Institute for International Economics in Washington,
D.C., who has called for a 4% target.
Factors such as aging populations, low economic growth and
higher savings rates are working to push down the neutral interest
rate, at which the economy is growing at a sustainable rate for the
long run and inflation is stable. As a result, central banks run a
greater risk of taking benchmark interest rates to zero or below
when seeking to support growth.
And yet, Norway's government said recently it would reduce its
central bank's inflation target, to 2% from 2.5%, arguing there was
no longer any reason to diverge from international norms. With
inflation near target, the central bank raised interest rates to
0.75% on Sept. 20.
The case for a higher target runs like this: Policy makers find
it difficult to cut benchmark interest rates much below zero. If
inflation is 2%, that means central banks can reduce the real
interest rate -- the benchmark rate minus inflation -- to minus 2%
by cutting the benchmark rate to zero. If inflation were higher,
say 4%, cutting the benchmark rate to zero would push the
inflation-adjusted rate to minus 4%, providing an extra kick for
the economy.
Higher inflation could have other benefits. It could help
economies adjust after a downturn by lessening the need for
outright wage cuts, because rising prices will erode wages anyway.
It could also make it easier for borrowers to pay down debt, though
that is something that lenders historically have always resisted. A
2009 study estimated that U.S. inflation of 6% for four years could
reduce the nation's debt-to-GDP ratio by around 20 percentage
points, similar to what happened after World War II.
Other economists have cast doubt on whether that level of
inflation would reduce the debt ratio by so much. And many worry
that central banks would struggle to push inflation to 6% anytime
soon, given how hard it was to hit 2%.
Vítor Constâncio, the European Central Bank's vice president
back in May, said at the time that while he had "no theoretical
objections" to a "mild" upward revision of the inflation target,
moving to a new target could undermine central banks' hard-won
credibility.
The ECB is among a group of central banks that have reduced
benchmark interest rates below zero, a novel move aimed at
providing extra stimulus to their economies. Former Fed Chair Ben
Bernanke has suggested that negative rates might be a better
alternative to higher inflation targets.
"Yes, negative interest rates raise a variety of practical
problems, as well as political and communications issues, but so
does a higher inflation target," Mr. Bernanke wrote in a 2016 blog
post. "In the political sphere, the fact that negative rates would
be temporary and deployed only during severely adverse economic
conditions would be an advantage."
Higher inflation can have drawbacks, as many economies have
learned through painful experience. It could distort the tax system
and mask economic signals, such as whether goods are rising in
price because they are scarce. Banks might demand an inflation-risk
premium when granting long-term loans, because high inflation can
lead to more volatile price movements, says Michael Schubert, an
economist with Commerzbank in Frankfurt. Thus, financing would
become more expensive, causing companies to invest less.
Crucially, an inflation rate of 2% allows households and
businesses to largely disregard price increases. That effect might
be lost if inflation is allowed to rise much higher.
"We know that some number higher than a 2% to 3% rate of
inflation will materially enter decision-making, because we have
had plenty of experience of higher rates of inflation that
demonstrates that," says Guy Debelle, deputy governor of
Australia's central bank. "How much higher though, we don't really
exactly know."
One possible solution: Central banks could allow inflation to
rise a bit above 2% without aggressively trying to bring it down.
That could give them more room for maneuver, and gradually inflate
away some of the world's enormous debt load.
It seems to already be happening in the U.S., where inflation in
August was 2.7%. The Fed has been raising rates, but only
gradually, and doesn't seem likely to step up its pace.
Although eurozone inflation has accelerated in recent months and
is now 2%, the ECB has signaled that it won't raise rates for about
a year.
Joseph Gagnon, a fellow at the Peterson Institute, says the Fed
"ought to tilt policy toward overshooting, not for its own sake,
but to avoid" undershooting its target again in future.
Mr. Fairless is a Wall Street Journal reporter in Frankfurt.
Email: tom.fairless@wsj.com.
(END) Dow Jones Newswires
September 23, 2018 22:18 ET (02:18 GMT)
Copyright (c) 2018 Dow Jones & Company, Inc.