Why central banks should target 4% inflation

Photo by Remy Steinegger

It is October 29, 1929 , also known as Black Tuesday. The Great Depression, one of the largest economic downturns in history, has just begun. Unbeknownst to the everyday man and woman, this will last a backbreaking decade, during which these everyday people will see their dreams slashed in the face of lower wages. That is, if they even find a job in the first place; unemployment will reach almost 25% in America at the height of the depression in 1933. During this time, it’s obvious that we will start looking to policymakers for solutions to this problem, however, even they have been silenced by the lunacy of the gold standard: there are no solutions in the pipeline.

Time for a voyage into the future. 1990, specifically – New Zealand. The Reserve Bank of New Zealand has just introduced a pioneering measure that will shake up monetary policy: the inflation target. They say they target a rate of price increase of 0 to 2%. Fast forward 22 years, and on the 25 January 2012, Ben Bernanke, the chairman of the most famous central bank in the world, the Federal Reserve, has introduced a 2% inflation target. Nowadays, the magic “2” is the norm, with central banks from the Bank of England to the Bank of Japan adopting the target. The problem? Well, there’s more than one, but the most arresting drawback is that we’re veering into very dangerous territory should we be even slightly amiss in meeting these targets.

Say we undershoot from our inflation target. That can happen, right? People make mistakes – even big, bad central bankers. If prices, therefore, appreciate by only 1% a year, that’s not too bad. But say we adjust the degree of error even more, and then we’re veering dangerously into deflationary territory – a nightmarish decrease in prices. In both my opinion and the opinion of many others, deflation is far worse than even high levels of inflation. This is because a deflationary slump in an economy causes people to think twice about purchasing goods and services, reducing demand for these goods and services, decreasing their prices to levels lower than they already are. Intuitively, this causes job layoffs as the reduction in demand causes a corresponding reduction in corporate revenue, and so the freshly unemployed aren’t very likely to buy non-essentials like a bottle of Coke or a packet of gum, let alone a new house. The ensuing vicious downward price spiral amidst a plethora of redundancies has historically been extremely difficult to get out of; deflation can batter an economy like nothing else. Where do we look for an example of this? Back to the past, that’s right – the Great Depression, where prices plummeted and redundancies soared due to a collapsing banking sector.

Moreover, recessions happen. We can’t prevent all of them, and it’s a fact of life that the average person is overwhelmingly likely to experience at least one or two in their lifetimes, if not many more. It’s how a central bank deals with the recession that defines how strong and robust their monetary policy is, and when you can only decrease interest rates by a small amount, then you’ve got a problem. Take the Bank of England. Interest rates currently sit at staggeringly low levels: 0.5%, to be precise. Let’s assume they meet their inflation target of 2%, and so the nominal interest rate (the interest rate when we don’t take into account inflation) will be 2.5%. Now, let’s hypothesise that they increase their inflation target to 4% and meet it (I know, I’m optimistic about their abilities). Now we have a wiggle room of a whole 4.5% should we face a recession, so we have a greater chance of stimulating the economy and getting it back on track. Even taking into account that central banks may not meet these targets, it’s logical to believe that they’ll at least achieve a higher inflation rate than before, and so regardless of the scenario, the overwhelming likelihood is that we’ll have more chance of beating back a recession than before.

Finally, we need to lend the companies that are the backbone of our economy a hand in being able to dish out nominal wage increases. Again, let’s take a scenario whereby we have higher inflation, say 3% (due to central banks undershooting the 4% inflation target) and the nominal wages of not very productive employees operating in, for example, McDonalds rise by 2%. In reality, they’ve still got 1% less purchasing power than they did before, however McDonalds’ 2% rise in wages keeps them happy and satiated; they won’t go on strike or resign or do all the things that corporations fear so much. Say we had a much lower inflation rate, perhaps 1%. Now, McDonalds is in hot water because they can only increase wages by a small, small amount, risking the ire of its employees. If the inflation rate went even lower, then we have even more of a problem; McDonalds cannot hand out relatively large nominal wage increases, as if they were to do so, their costs would increase, therefore enabling a reduction in profits. So now we have annoyed corporations, annoyed employees and perhaps an economy on the verge of recession, with very little room to alter interest rates when we enter one. All because of those dastardly low inflation rates.

Since 1990, the inflation target has become one of the key symbols of monetary policy and central banking. We need to increase it; I think it’s time to change this symbol for the better.

Do you?

Shrey Srivastava, 16

17 Comments Add yours

  1. Gaurav Srivastava says:

    Shrey, I read your article carefully and agree with this idea which should result in significantly less recessions going forward. Moreover higher inflation is much less worse than deflation.. so I’m upfor choosing lesser of the two evils! Well done.

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  2. moslerfan says:

    Hi Shrey, I think the key to inflation is not money creation, as the monetarists would have it, but the use of money to buy output. Obviously the quantity of money plays a role here, but so does getting money into the hands of people who will spend it. The tool that governments have to do this is not interest rate manipulation, it’s deficit spending. Deficit spending, preferably via infrastructure building or broad based tax cuts until inflation hits your target, should do the trick.

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    1. I agree completely, apart from your first statement where you said that the key to inflation isn’t money creation; I think it can be in conjunction with what you said, which is using money to buy output. Thanks for the comment! 🙂

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      1. moslerfan says:

        What I meant by the first statement is that money that is not spent can’t have an effect on prices (or then, inflation.) There’s a quote from David Hume’s “On Money” that goes something like “Coin that is kept in boxes is as if it never existed.” This is zero velocity money. The key to increasing velocity is putting money into the hands of people who will spend it, preferably on consumption of newly produced goods and services, not just for bidding up prices of previously existing assets like stocks, high end real estate or Old Masters paintings.

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      2. Thanks for the comment! I understand that, yet how would you put money into the “hands of people who can spend it?” Progressive taxation? Interest rates? Thanks again for the comment 🙂

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  3. Erik Hare says:

    I am thinking a lot about the limits of monetary policy. I do agree – a higher inflation target is a good thing. It encourages risk taking, which is in such short supply now. But, overall, I don’t know how we get to that point. As previous comments said, it’s really about the velocity of money – which keeps falling even today. Policy has to be directed towards increasing velocity.

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    1. Thanks for the comment! How would you go about increasing velocity? 🙂

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  4. jbuc61 says:

    “In both my opinion and the opinion of many others, deflation is far worse than even high levels of inflation. This is because a deflationary slump in an economy causes people to think twice about purchasing goods and services, reducing demand for these goods and services, decreasing their prices to levels lower than they already are. ”

    But a drop in prices will increase demand, not reduce it. I think we should shoot for deflation rather than inflation. What the average consumer ultimately wants is more purchasing power. They want to be able to purchase more with their income of work less and be able to cover all their costs. The idea that a rising cost of living is a good things seems very backwards to me. If you compare cost of living now compared to say, 30 years ago.. you can see that wages have not grown at the same rate as living costs. We have offset this by taking on more personal debt and having more double-income families instead of having one parent stay home to help raise kids.

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    1. Thanks for the comment 🙂 Deflation makes it harder to carry out nominal wage increases, thereby meaning that companies have to, essentially, cut jobs, and this causes less people to want to buy goods or services, hence depressing aggregate demand. Thanks again for the comment 🙂

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      1. jbuc61 says:

        Price reduction can be a result of improved efficiency though. You wouldn’t need wage increases in a deflationary situation because a fixed income would lead to stronger purchasing power.

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      2. The workers wouldn’t realise that though, hence the issue for companies.

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  5. LiberteKev says:

    This was a good read although I think inflationary measures have the unintended consequences of hurting the poor more than the rich. Inflation is a hidden tax used by central governments to fund their ventures. Sometimes these are public goods that help society, other times they are wasteful and just inundate future generations with public debt.

    Sure we like to see our wages and assets appreciate, but inflation is what also leads to malinvestment and credit bubbles. It would be a very dangerous road to go the high inflation route.

    Good read, but there is definitely more to it in my opinion.

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  6. Zachary says:

    This is an idea that agree with in general. I would like to give one additional pieces of support, and one possible case of dissent for the idea.

    The first consideration is recent trend of declining inflation expectations. Inflation expectations are a very strong determinant of actual inflation, and for at least the past ten years they have been pegged pretty closely to 2%. It is only recently that we see a decline in these expectations, which can exacerbate the problem of creating additional inflation(think Japan). Assuming a reserve bank can maintain credibility, an increase in the target rate would increase expected inflation, which would actually help to create additional inflation.

    There is a potential for problems however when we consider the evidence of a convex Phillips curve. If we take the case of a higher inflation target, and a convex Phillips curve, we will find that any deviations from NAIRU will lead to larger fluctuations in the inflation rate. This poses two problems. First, increased volatility in the inflation rate has the potential to undermine the credibility of a reserve bank, making it more difficult to adjust policy to reflect economic conditions. The second, is that any increased volatility in the inflation rate will cause an increased inflation risk premium on longer term bonds, causing higher real interest rates, and potentially harming a reserve bank’s ability to use accommodative policy near the zero lower bound. Though this is somewhat balanced by the effect of higher nominal interest rates decreasing the probability of actually reaching the zero lower bound.

    This is getting long, so I’ll stop here, but over all this is a very good summary of support for an increased inflation target.

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  7. adampiacquad says:

    I’d have to say I disagree here. Natural deflation is the essence of free market capitalism: we pursue innovation that makes goods and services cheaper and more affordable and increases sales. A computer would not be a staple in every home unless efficiency made it possible. In fact the entire industry would merely be on the fringe if prices did not deflate. This cannot happen when banks are trying to target inflation. Consumers are tugging for deflationary pressures to alleviate their household debts while banks are feeding in new cash that creates inflationary pressure on many goods such as real estate and stocks. Banks will never be able to achieve the inflation they desire. Direct helicopter stimulus would be even worse, I’m afraid. It would cause rapid inflation as consumers run into the market to buy new products. Of course that ends up destroying savings as each dollar in the bank becomes more and more worthless.

    As for the gold standard, little is understood about it, especially among central bankers like Ben Bernanke. He claims gold standard starved the economy of its ability to recover, yet it was really new deal programs that prevented recovery. Prior to that great depression, America began to print money in response to Great Britain doing the same in order to decrease the price of exports after the world war. Gold standard is an extremely effective way to keep the central government in check as it prevents them from printing money in response to crises.

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