To target low inflation or to target high inflation: that is the question

Whether ’tis nobler in the mind to suffer
The slings and arrows of outrageous inflation,
Or to take arms against a sea of inflation expectations,
And by opposing end them?

Never has Shakespeare been so crudely adapted, but I am going somewhere with this so bear with me. There is an interesting debate currently taking place amongst economists regarding the subject of inflation. On one side we have the intellectual heavyweights of Olivier Blanchard (The Chief Economist at the IMF), Paul Krugman (winner of the Nobel Prize in economics) and Ken Rogoff (Harvard University Professor, former IMF chief economist and chess Grandmaster). On the other side we have the men in charge of monetary policy.

We are now all familiar with the actions that governments and central banks had to undertake in the aftermath of the financial crisis. Record low interest rates, huge fiscal stimulus (and hence deficits) and extraordinary policy measures such as quantitative easing have been the medicine that economies like the US, Europe and the UK have needed to support their respective financial systems. Ironically, the financial market investors that took excessive risk and had to be saved by governments are now punishing those governments that bailed them out.

There is now a considerable divide in opinion about what should be done to address the deficits and general debt levels that many nations now face. In Rogoff’s view as shown in The Guardian, “it is time for the world’s major central banks to acknowledge that a sudden burst of moderate inflation would be extremely helpful in unwinding today’s epic morass” (a morass is an area of low-lying, soggy ground – I had to look it up). On the large amount of debt that governments have, Rogoff noted that  “Moderate inflation in the short run – say, 6% for two years – would not clear the books. But it would significantly ameliorate the problems, making other steps less costly and more effective.”

Rogoff is probably the punchiest in the ‘we should be targeting higher inflation outcomes’ debate. But Olivier Blanchard isn’t far behind, especially considering where he is currently employed. Blanchard says that the financial and economic crisis has “exposed flaws in the pre-crisis policy framework” and “forces us to think about the architecture of post-crisis macroeconomic policy”. He notes that “If we had had more margin to play with on interest rates, we would probably have had to use fiscal policy less [in the recession]”. He believes that higher inflation and higher interest rates in normal times would have costs, but this may be a price worth paying because it would make monetary policy more effective during crisis periods.

Not to be outdone, Krugman believes “even in the long run, it’s really, really hard to cut nominal wages. Yet when you have very low inflation, getting relative wages right would require that a significant number of workers take wage cuts. So having a somewhat higher inflation rate would lead to lower unemployment, not just temporarily, but on a sustained basis.”

And what do the central bankers think of all this? Certainly they are not too pleased, after spending the large majority of their careers attempting to gain credibility for a low inflation targeting monetary policy regime. This was Trichet’s response in the recent Q&A on monetary policy to a question on Blanchard’s IMF paper suggesting an inflation rate target of 4% may be more appropriate than the current 2 % target:

“I would say that it is plain wrong. That is my opinion and I believe it is the opinion of all central banks I know… I think it is totally counterproductive in the present period, when we have to cope with a difficult situation, to contribute to unanchoring inflation expectations….it is extremely dangerous…”

Inflation targets are unlikely to be changed for now and the debate at this stage appears to be purely academic.  However that doesn’t mean that inflation targets can’t or won’t  be changed in future.  Economics is an evolving discipline – it was as recently as the 1980s that the UK targeted the money supply, but this was abandoned when it became clear that the policy didn’t really work and led to unsatisfactorily high levels of inflation.  Inflation targeting has gained traction internationally since the early 1990s, and had – until recently – been deemed a success pretty much universally.  It’s dawned on people that maybe a low and steady inflation rate wasn’t due to targeting, but was simply due to the opening up of China and globalisation generally, which helped improve technology and led to productivity gains. Arguably the natural state for the world in the past two decades was deflation, but deflation of a good kind – falling prices due to better productivity, as experienced in the US in the late 19th century.  Trying to hit an inflation target meant running unnaturally loose monetary policy, which helped contribute to the bubbles we saw in the noughties.

I think fiddling with the inflation target may be the wrong debate to be having right now. Certainly in the current environment, securing a self-sustaining recovery whilst maintaining low and stable inflation expectations is the thing that is of most importance to politicians and central bankers alike.  And let’s not forget, it’s the politicians that set the appropriate target for the central bankers. Perhaps implementing in the UK and Europe a US style ‘dual mandate’ –  targeting full employment and price stability – is more appropriate in the current environment.