Two Percent ‘Makes Sense’ as Central Banks Fight Low Inflation

  • Mishkin says policy makers shouldn’t be afraid to overshoot
  • Borio says more tightening acceptable to tame financial booms

Central banks’ mandates may not have to change, but more flexibility is needed in interpreting them.

That’s the conclusion of a panel in Vienna on whether a 2 percent inflation target is still appropriate after years of financial crises have eroded growth potential around the world and policy makers have taken on additional tasks beyond guaranteeing price stability. Some warned that demonizing deflation might lead to the creation of new bubbles.

A quarter of a century since New Zealand opened the era of inflation-targeting, central banks around the world are undershooting their consumer-price goals, but rather than lowering their sights to make things easier, the misses have fanned calls for targets to be increased. The most prominent proposal came from International Monetary Fund economists, who have suggested 4 percent as a new normal to prevent interest rates from being stuck too close to zero.

Frederic S. Mishkin, the Columbia University economics professor who served as a Federal Reserve Governor from 2006 to 2008, argued in a paper presented at an Oesterreichische Nationalbank conference that while central banks’ long-term inflation goal shouldn’t be raised above 2 percent, policy makers shouldn’t be afraid to exceed that rate. In fact, they should try to overshoot their target in the current circumstances, provided they have previously undershot.

Mishkin’s research was discussed by Gabriel Fagan, the chief economist of the Central Bank of Ireland, who concluded that “2 percent forever makes sense for a long-term inflation target.” At the same time, “in the current economic environment, central banks should not be afraid of exceeding the 2 percent target but should in fact aim to go a little bit above 2 percent in order to compensate for the undershooting,” he said.

Former Bank of England Deputy Governor Charlie Bean said the main reason why raising the inflation target has so far been rejected is that “you lose the benefit of what we refer to as stable pricing.”

“A 2 percent average inflation is something you can forget about, you don’t have to worry what happens to the price level,” he argued. “That’s not true with 4 percent. If the central bank declared it was pursuing 4 percent, unions would expect to have indexation. You move into a world where people would have to start factoring it into their decision making.” 

Zero-Lower Bound

The idea behind a higher inflation goal is to give central banks more leeway to respond to adverse shocks, as interest rates are less likely to hit the zero-lower bound -- a level at which it becomes harder to fuel price growth given the central bank has to rely on non-standard tools such as asset purchases and forward guidance.

As those policies come with their own risks, especially that of inciting new financial booms, it may even be necessary to accept periods of deflation rather than targeting higher inflation, according to the chief economist of the Bank for International Settlements, Claudio Borio. He said central banks need to target financial stability along with price stability, incorporating policies to “lean against the wind” when asset booms emerge, tightening monetary policy to head off financial stability risks.

“Not all disinflations, or indeed periods of falling prices, are born equal and hence amenable to the same treatment,” he said. “Indeed, there is a risk that by fighting too hard against benign disinflation, or even deflation, a central bank may be sowing the seeds of malign disinflation in the future. This would occur if in the process it fueled the build-up of financial imbalances.”

A policy that would tolerate persistent deviations of inflation below targets to keep the financial side of the economy “on an even keel” wouldn’t require a mandate change, Borio argued.

“A close reading suggests that the room for interpretation is often considerable,” he said. “But it may require at least refinements in how the mandates are put into practice.”

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