One of the scariest scenario's is an exogenous shock causing a recession before we have recovered from 2008-2009. At that point the central banks would pretty much be impotent and the game would be up.
From VoxEU:
Since the double-digit inflation of the 1970s, central banks have sought to reduce inflation and keep it low. This column argues that recent history teaches us that inflation has fallen too low. Raising inflation targets to 4% would have little cost, and it would make it easier for central banks to end future recessions.HT: FT Alphaville
Many central banks have adopted a common policy – an inflation target near 2%. These central banks include the Fed (which calls it a ‘long run goal’), the ECB (which targets inflation ‘below, but close to 2%’) and the central banks of most other advanced economies.
A number of economists, such as Blanchard et al. (2010), have suggested a higher inflation target – typically 4%. Yet this idea is anathema to central bankers. According to Ben Bernanke (2010a), the Federal Open Market Committee unanimously opposes an increase in its inflation goal, which ‘would likely entail much greater costs than benefits’.
I examine the case for a 4% inflation target in a recent essay (Ball 2013) and reach the opposite conclusions to those of Chairman Bernanke:
A lesson from the Great Recession Recent history has demonstrated the problem of the zero bound. In response to the US financial crisis and recession, the Fed reduced its target for the federal funds rate from 5.25% in August 2007 to a range of 0 to 0.25% in December 2008. The target remains in that range today. Yet this sharp monetary easing has not restored full employment. The unemployment rate peaked at 10% in 2009 and then stayed high; in April 2013, it was 7.6%. Unemployment of 5% – widely considered the natural rate just a few years ago – is nowhere in sight.
- A 4% target would ease the constraints on monetary policy arising from the zero bound on interest rates, with the result that economic downturns would be less severe.
- This important benefit would come at minimal cost, because 4% inflation does not harm an economy significantly.
During past recessions, the Fed has reduced interest rates and kept reducing them until unemployment fell to an acceptable level. But cutting interest rates has not been feasible since 2008. With nominal rates already near zero, they cannot fall farther. Nobody would lend at a negative interest rate because one can do better by holding cash.
As the US recession spread around the world, many other central banks reduced interest rates to 1% or less. Like the US, their economies are stuck in the ‘liquidity trap’ described by Keynes (1936). Unemployment is high and policymakers cannot reduce it with interest-rate cuts.
In general, a higher inflation target reduces the zero-bound problem. In long run equilibrium, a higher inflation rate implies that nominal-interest rates are also higher – the Fisher effect. When a recession occurs, rates can fall by more before hitting zero, making it more likely that policymakers can restore full employment.
Suppose that central banks had been targeting 4% inflation in the early 2000s rather than 2%. Nominal-interest rates would have been two percentage points higher, allowing rates to fall by an extra two points before hitting zero. I estimate that this extra stimulus would have reduced average unemployment over 2010-2013 by two percentage points (Ball 2013).
Future risks from the zero bound
Looking forward, the case for a higher inflation target depends on the risk that interest rates will hit zero in future recessions. Some economists believe that this risk is low. Mishkin (2011), for example, argues:
“Although [the zero bound] has surely been a major problem in this recent episode, it must be remembered that episodes like this do not come very often. Indeed, we have not experienced a negative shock to the economy of this magnitude for over seventy years. If shocks of this magnitude are rare, then the benefits to a higher inflation target will not be very large because the benefits will only be available infrequently.”In my view, Mishkin understates the risk of the zero bound. If we look beyond the US, the crisis of 2007-2009 is not unique in recent history. A completely separate financial crisis pushed Japanese interest rates to zero in 1997. It was only around 1990 that central banks began to target inflation rates of 2% or less. The two largest economies that adopted this policy both hit the zero bound within 20 years....MORE
