Should we accept lower than 2% inflation?

27th June 2019 Off By binary
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Here’s Scott Mather in the Financial Times:

Central banks around the world are pivoting toward easier monetary policy. In pursuit of a 2 per cent target for inflation, major central banks seem willing to exhaust their monetary policy ammunition at a time when economic output is at — or above — potential.

In fact, monetary stimulus does not exhaust ammunition, it adds to ammunition by raising the equilibrium interest rate.

Unfortunately, there is little evidence to suggest that lower policy rates are successfully generating either better real growth outcomes or higher inflation. 

That comment may reflect the fact that lower growth and lower inflation cause lower interest rates. So the correlations are not what one might expect. Nonetheless, Mather worries about the effect of low interest rates:

In some countries, this policy stance has the potential to reduce monetary policy effectiveness, create imbalances that may sow the seeds for the next crisis, and leave central banks powerless to respond to that crisis. It is time to ask whether the 2 per cent inflation target has outlived its usefulness.

But is lowflation really that bad:

Although economic recessions are typically accompanied by disinflationary forces, it is far from clear that disinflation or small negative rates of deflation actually cause economic crises. Japan has had such an environment for much of the past two decades, but its real economic growth per capita looks very similar to that of the US or Europe over the same time period.

One result of this Japanese low inflation policy is extremely low interest rates. But Mather seems to be suggesting that low interest rates are a problem, which can lead to financial excesses. So would higher rates be better? And if so, don’t we need higher rates of inflation? Here’s Mather:

And while likely fuelling these risks and distortions, low rates are clearly not delivering targeted inflation, and they may even be having the opposite effect. It has recently been observed that low rates correlate to low inflation outcomes, perhaps because they cause inflation expectations to fall rather than rise.

This is precisely why so many New Keynesians have recently advocated raising the inflation target to 4%. A higher inflation target would allow for higher interest rates. But Mather seems to go in another direction:

The “natural” rate of inflation may fluctuate over time because of the forces of technology, globalisation, demographics and so on. With potential growth rates that are barely positive and falling in places like Europe and Japan (owing much to challenging demographics), 2 per cent may also not be the natural inflation rate for every region. If this is the case, then inflation targets should be looser, more variable over time, and differ across countries with different economic structures.

There is no “natural” rate of inflation; only real variables have natural rates. One might argue that the “optimal” rate of inflation is different in slow growth countries, but in that case the optimal rate is likely to be higher, not lower. It is fast growing countries that have very low optimal rates of inflation.

HT: Stephen Kirchner

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