Central banks by and large try to pin inflation to 2%. When prices rise above that, central banks lift rates, people lose jobs, the economy slows and prices slink back down. The higher inflation, the harder it is to muscle back down. Going from 8% to 4% will be tough and take time. Going from 4% to 2% will be even tougher, especially because by then, many will have lost jobs and the economy will be stalling. Why not make it a little easier and raise the target slightly?
Two great pieces in the FT over the past week on the issue.
Ethan Wu in the FT lays out the temptation for central banks succinctly:
It’s no large leap to imagine a scenario where inflation is falling but still above target, while unemployment is rising but not yet recessionary. The political pressure to loosen policy would be immense. The Fed might conclude raising its inflation target, or at least acting chill about enforcing it, is the best of a bad set of options.
Well, people might not believe the new target, goes the counter argument. If people suspect the central bank will goes easy on inflation today, they’ll expect the same again tomorrow. The result is inflation tends to stick around.
Still, the idea of lifting the inflation target slightly to 3% or 4% is gaining traction. In an opinion piece last November Olivier Blanchard, an economist who has banged this drum since at least 2010, dusted off the idea. He spoke to the FT again about whether changing the target will make people distrust central banks:
I think, in the right environment, a one-time goalpost move would be credible. There is no slippery slope here. It is clear that the earlier conclusions and computations that 2 per cent was the right target, and the probability of hitting the ZLB was small, were wrong. I think any reasonable economist, including [Harvard’s Kenneth Rogoff and Gramercy’s Mohamed El-Erian], agree about that. I think there is zero risk of moving the target further and further. I heard the same argument about credibility when central banks started QE.
I share Blanchard’s skepticism about slippery slope arguments. Trust does not grow in a vacuum. I treat differently the friend who repeatedly borrows and fails to repay money, to the one who faithfully repays me, but one day comes in tears, to say they lost their job, and need more time. Context matters, history matters.
Andy Haldane, former Bank of England chief economist argues for a third way. Central banks should fudge the issue and promise to get back to 2% eventually. He sees the 2% target as a relic of an era where inflation was kept low by globalization (cheap transport / cheap labour, predominantly in China). That’s over he says, and we’re now in an era where inflation will be buoyed up (trade wars make transport expensive and Chinese workers want higher wages). The 2% target should be shelved until this passes.
But the line is thin between a permanent change and a pause for an undefined amount of time. If they’re both likely to undermine credibility, better to make the change and be done with it.