In an International Monetary Fund (IMF) staff position note in 2010, Olivier Blanchard and his colleagues argue that it could be useful to consider, during normal times, raising the inflation target of central banks in advanced countries. Specifically, they point to raising the inflation target from 2 percent to 4 percent to be able to avoid the zero interest rate bound when an advanced country central bank has to cut rates during periods of deflationary recessions. “Should policymakers,” they ask, “therefore aim for a higher target inflation rate in normal times, in order to increase the room for monetary policy to react to such shocks?”
John Williams, the president of the Federal Reserve Bank of San Francisco, also recently raised, for the purpose of Fed policy normalization debate, the same point that Blanchard and his IMF colleagues made in their paper. It is doubtful, however, if raising the inflation target is a viable proposition during these still abnormal times when the United States continues to be near the zero bound and the eurozone and Japan are experimenting with negative interest rates primarily to boost inflation to their 2 percent target.
The debate about raising the inflation target from 2 to 4 percent by advanced economies requires analysis during two time periods – normal times and deflationary times – as Blanchard and Williams respectively brought up. The behavior of the central bank would be similar to how it would behave when targeting 2 percent inflation. During normal times, a 4 percent inflation target requires the central bank to hold off on raising interest rates until long term inflation expectations rise beyond 4 percent. In periods of deflationary recessions, monetary policy normalization cannot take place, likewise, until long term inflation expectations rise beyond 4 percent.
A central bank, during both normal and deflationary time periods, may preemptively begin its monetary tightening policy once it sees, in data, long run inflation expectations rising potentially beyond the 4 percent target. Further, during both time periods, the central bank will have longer wait times to tighten monetary policy because inflation has to rise in forecast beyond 4 percent. In other words, the economy would be around the “natural” interest rate during normal times, and during deflationary times it would be at lower interest rates for prolonged periods until the whites of the eyes of inflation rising beyond 4 percent can be seen in the data.
In both normal and deflationary periods, contrary to expectations by policymakers that a higher inflation target would increase monetary policy room to react to negative shocks to the economy and help policymakers avoid the zero interest bound, it is not clear what the “natural” interest rate is and if it would be high enough to provide policymakers the room they desire to cut before the zero interest rate bound can be reached.
A higher inflation target could have nominal effects by simply raising prices and wages or have real effects by raising the potential growth rate of an economy. It does not, however, say much about an economy’s “natural” interest rate to expect that rate to be comfortably high enough to avoid the zero bound on the way down when necessary. If anything, the “natural” rate would be low enabling the central bank to tolerate inflation at a higher target such as 4%.
During deflationary times, such as nearly the past decade in advanced economies, a very large and sustained fiscal expansion accompanied by very gradual monetary contraction from the zero bound is a sound approach to normalizing monetary policy, not raising the inflation target.