In 2010, Olivier Blanchard, who at the time was chief economist at the International Monetary Fund, committed economic heresy by suggesting the inflation targets of central banks should be set at 4 percent, two percentage points higher than what had become the global convention. Central bankers in advanced countries were performing all sorts of real-time experiments with monetary policy to stave off deflation. Blanchard reckoned that if the Federal Reserve, the Bank of Japan and others had been willing to accept higher inflation ahead of the financial crisis, they would not have been backed into a corner so quickly by the forces the crisis left in its wake.
“It remains a fact that compared to conventional policy, the effects of unconventional monetary policy are very limited and remain uncertain,” Blanchard wrote in a blog post in 2013. “There is therefore much to be said for avoiding the trap in the first place in the future, and it raises again the question of the inflation rate. There is wide agreement that in most advanced countries, it would be good if inflation was higher today. Presumably, if it had been higher pre-crisis, it would be higher today. To be more concrete, if inflation has been 2 percentage points higher before the crisis, the best guess is that it would be 2 percentage points higher today, the real rate would be 2 percentage points lower, and we would probably be close in the United States to an exit from zero nominal rates today.”
Deflation remains a worry in many developed economies. Central bankers have created hundreds of billions of dollars to buy financial assets. They dropped benchmark interest rates to near zero years ago and have left them there. A growing number even are trying negative interest rates to counter “lowflation.” Yet none have been willing to experiment with setting their inflation targets above 2 percent. A review of recent history by economists at the Bank of Canada shows the policy regimes of the main central banks are essentially the same as before the financial crisis: they have added lots of new tools, but the goal remains the same. The Bank of Japan raised its target in 2013 -- to 2 percent from 1 percent, catching up with the global norm. The Reserve Bank of New Zealand (RBNZ) and the government agreed in 2012 to aim at the midpoint of its comfort band of 1 percent to 3 percent, a stronger commitment to keep inflation at 2 percent than had existed previously.
“Subsequent RBNZ commentary has suggested that this explicit focus on the midpoint helps anchor expectations near 2 percent, making the outlook more resilient to temporary deviations of inflation from the target band and helping to avoid inflation expectations becoming biased at either end of the target range,” the Bank of Canada’s Robert Fay and Kristina Hess wrote in their article for the latest edition of the Bank of Canada Review.
The devotion to 2 percent is remarkable given its initial adoption amounted to an educated guess. New Zealand was the first country to adopt an inflation target, including it in the legislation that granted the Reserve Bank autonomy from the government in 1989. As Neil Irwin of the New York Times recounted in 2014, the finance minister, David Caygill, and the head of the newly-independent central bank, Donald Brash, had no idea what the inflation target should be. In 1988, Caygill’s predecessor had said he would aim for inflation of between 0 and 1 percent. “It was almost a chance remark,” Brash told Irwin. “The figure was plucked out of the air to influence the public’s expectations.” Caygill and Brash used 1 percent as a starting point, eventually settling on a range of 0 to 2 percent. It became official policy in March 1990.
Canada was the next country to adopt an inflation target, doing so in February 1991. The Bank of Canada is studying whether it should raise the target, as its five-year mandate from the government is up for renewal this year. A change seems unlikely. The more research the central bank publishes on the subject, the more the consensus hardens around the current goal of hitting the midpoint of a range of 1 percent to 3 percent.
Another group of Bank of Canada researchers this week published a study that at first appears to favour a higher inflation target, but ends in a defense of the status quo. Wages are sticky during downturns because workers resist pay cuts even when times are tough, and because employers are reluctant to do anything that would harm staff morale and productivity. This phenomenon, known as downward nominal wage rigidity, weakens the recovery because employers end up firing workers to offset their losses. Theoretically, faster inflation alleviates the need to fire people; as long as nominal wages remain unchanged, employers benefit from a reduction in real wages. But with post-crisis inflation so low, and nominal wages stuck, employers’ only response was layoffs (or deeper losses).
That sounds like an argument for faster inflation, and by extension a higher inflation target. The Bank of Canada research team even found evidence that downward nominal wage rigidity is stronger now than it was previously. But the group concluded that a higher target was unnecessary. That’s because once monetary policy reaches its effective lower bound, the forces of downward nominal wage rigidity work against disinflation and may actually bring about a faster recovery, according to the Bank of Canada’s Robert Amano, Dany Brouillette, Stefano Gnocchi and Natalia Kyui.
The resistance of the central banking establishment to raising the inflation target doesn’t necessarily mean Blanchard was wrong; these are the people who thought they had solved everything with the Great Moderation, after all. But even if 2 percent remains the standard, Blanchard may have helped kill the notion that central bankers should be aiming for no inflation at all. With prices rising slowly in Australia, some economists have been calling for a lower target to match the new reality. The country’s central bank is having none of it.
“It would be wildly premature to actually change the target on the basis of what we know now,” John Edwards, a member of the Reserve Bank of Australia’s policy committee, told the Wall Street Journal in an interview this week. “It would be a calamity to adjust the target downwards and then discover inflation is on the way back up again.”
