The notion that central banks should set an inflation target higher than 2% has longstanding support among many economists, including former chief IMF economist Olivier Blanchard, and has remained persistent even amid efforts to bring inflation down. As new data become available, however, the case for 2% — the US Federal Reserve’s current target — is looking stronger.
In the UK, core inflation rose to 7.1% in May. In the eurozone, core inflation has stayed at about 5%. The US is doing only slightly better with core inflation above 4.5%.
There is some chance that the US may experience a proverbial “soft landing,” but that scenario is harder to imagine for the eurozone and the UK. Most mortgages in the UK are floating rate, for example, so sharp upward pressure on interest rates from the Bank of England could crush its housing market.
After the pandemic, inflation rates rose sharply in many countries, for a variety of reasons: loose monetary policy, loose fiscal policy, energy price shocks, and so on. Much of that policy excess was mistaken, as Lawrence Summers noted at the time. The broader point is that during crises, the risk of overreaction is very real. That fact should shift the calculus on the optimal inflation target.
For a long time, the focus was on the risk of underreaction, such as when the US had too little monetary and fiscal stimulus following the 2008 financial crisis. That was a myopic perspective, and so those commentators wanted an inflation target of say 4% to limit the possibility of aggregate demand shortfalls in the future.
Imagine the US had followed that advice and entered 2019 with a 4% inflation target. If the same pandemic had come, and the same monetary and fiscal responses had been pondered, how might things have been different?
One possibility is that there would have been worries about an overreaction, with an already high 4% inflation rate, and less would have been done on the monetary and fiscal side. Still, even in the best-case scenario, inflation rates would probably have ended up at least as high as under the status quo, given that the US was starting from a higher base inflation rate.
More realistically, there probably would have been an equally vigorous monetary and fiscal response. At the time, expansionary advocates believed that it would fill an output gap rather than boost prices, and neither markets nor most economists expected anything like the resulting inflation rates. It is likely that these same mistaken beliefs would have prevailed at a starting point of a 4% inflation rate.
So rather than having inflation in its current range, it would have been several percentage points higher. Meanwhile, the subsequent dilemmas of central banks would have been tougher — and that higher inflation rate has damaged real wages all the more.
From today’s vantage point, it is hard to say whether an overreaction or underreaction to the next crisis is more likely. But it is increasingly obvious that inflation remains extremely unpopular politically. UK Prime Minister Rishi Sunak’s chances of reelection, for example, largely depend on the Bank of England getting inflation under control. He has even pledged to cut the inflation rate in half, just as President Joe Biden’s nominees for the Federal Reserve have pledged to get inflation under control.
Might it be that a 4% steady-state rate of inflation simply isn’t politically stable? A party defending a 4% target might be vulnerable to an opposition party pledging a lower target, or to a populist party pledging some imaginary “free lunch” that does away with inflation altogether. When a 4% inflation target was first proposed, these political risks seemed far less plausible than they do today.
The “liquidity trap” arguments for a 4% inflation rate are complex, and I strongly suspect they are not political winners, given the unpopularity of inflation. For better or worse, this is no longer a world in which elites can simply do what they deem best, without much popular support.
There may well be ways of improving on current central bank mandates, but moving to a 4% inflation target isn’t one of them. It was always a fantasy that such policies would offer an extra layer of protection. Instead, the last few years stand as yet another illustration of a longstanding truth: It’s very easy for government policy to create excess inflation, but it’s very hard for it to bring inflation under control.
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