Monetary policymakers in big, developed economies have experimented wildly with real money trying to stave off crisis. Yet with inflation returning in places as recovery takes hold, they share a blinkered faith in a theoretical 2 percent annual inflation goal – despite scant evidence that even far higher rates harm growth. As rich nations struggle with debt, the credo merits an open-minded rethink.
Nobody could accuse central bankers of inflexibility in recent years. In an effort to spare the United States a repeat of the Great Depression, the Federal Reserve has expanded its balance sheet by about $2.6 trillion – equivalent to almost a fifth of GDP. The Bank of England has not been far behind, with a 200 billion pound intervention equal to about 15 percent of output. Even the more conservative European Central Bank has most recently bought about 74 billion euros-worth of assets.
Despite such huge real-world experimentation one aspect of monetary policy has remained unchallenged by central bank chiefs – the level of inflation they consider it appropriate to target.
To judge from the clustering of rich nations’ central banks around the 2 percent standard, an observer might think it is a highly scientific number. In fact the target – which the Bank of England and the ECB embraced in the 1990s – is relatively arbitrary. Many central bankers cut their teeth fighting inflation in the 1970s and early 1980s. Presumably a low single-digit inflation rate seemed close enough to zero to be safe from the Scylla of runaway prices, while also leaving some room to steer away from the Charybdis of deflation.
Not much room, of course. But few were especially worried about deflation 15 years ago, nor about how a central bank might handle long periods with interest rates near zero. One study in 2000, for example, estimated that the fed funds rate would bump down to zero only 5 percent of the time, and typically would stay there only a year. After two years pressed against the zero bound, this U.S. assumption now seems misplaced.
With the rulebook going out of the window in other ways, it’s odd that the optimal level of inflation hasn’t come under more scrutiny. One reason, of course, is that rampant inflation and the battle to quell it 30 years ago was hugely costly for many nations, crimping growth and swelling the ranks of the unemployed. Officials are understandably nervous about giving up their subsequent hard-won credibility.
Many also fear that any relaxation of inflation targets would inevitably lead to hyperinflation, which is economically nightmarish because it makes it impossible for firms, savers or governments to plan ahead. And now that rich nations’ central banks have either explicitly or implicitly embraced a fairly consistent target, they are unwilling to let it go.
Still, the debate is worth having. There is little evidence of harm from inflation rates several times higher than 2 percent. Harvard’s Robert Barro, a free-market economist, suggests that until annual inflation passes 10 percent it has no discernible negative effects on real growth. And nations have prospered with surprisingly high price rises.
Brazil, for instance, managed to achieve world-beating per capita real income growth of 4.5 percent a year in the 1960s and 1970s, despite inflation rates close to 40 percent. In the United States, the economy grew by an average 3.2 percent annually in real terms during the 1970s while inflation averaged 7.8 percent. In the 2000s, by contrast, consumer prices rose on average just 2.4 percent a year, but real GDP grew at only half the pace seen in the 1970s.
Out-of-control price increases are not to be encouraged. But the rewards of low inflation remain elusive. Subdued price rises in the developed world in the run-up to the 2008 crisis plainly didn’t deliver any special degree of economic stability. Nor have real growth rates been superior in most nations.
And there are appealing practical reasons to ease the choke-hold. An inflation rate of 4 percent in the United States, for example, would in real terms erode an extra $1 trillion of consumers’ debt burden over the coming five years, as compared to the effect of 2 percent inflation, according to Moody’s Economy.com. Slightly higher inflation would also tend to boost home prices, thereby easing the problem of underwater mortgages.
Relaxing inflation targets would be anathema to many and would unquestionably bring dangers. But the world’s central bankers have freely dumped their traditions in other areas. Whatever they might conclude, they shouldn’t shy away from questioning their old assumptions about inflation, too.