The author is C Fred Bergsten Senior Fellow of the Peterson Institute for International Economics
In 2010, Giovanni Dell’Ariccia, Paolo Mauro and I argued for an inflation target of 4%. At the time, central banks overwhelmingly rejected the idea. The reason was not so much a disagreement with logic, but the perception of a risk that if they did, they would lose credibility. The time has come to return to the argument.
Twelve years ago, our case was based on a simple cost-benefit analysis. On the plus side, a higher target and, by implication, higher average nominal interest rates would give monetary policy more leeway to cut interest rates when needed, thereby reducing the risk of being constrained by the lower bound of zero.
When the 2 percent inflation target was chosen, its proponents argued that it would imply average nominal rates that were high enough to leave enough room for monetary policy to cut rates without hitting that lower limit. This turned out to be wrong; the zero lower bound was more restrictive than expected. An inflation target of 4 per cent implied, all other things being equal, average nominal rates 2 percentage points higher, and would thus leave more room for maneuver for monetary policy.
On the cost side, the empirical evidence of retargeting suggests that while high inflation, say 10% or more, can be very costly, the additional costs of 4% inflation over inflation 2% are low. The main costs came from the distortions of an insufficiently indexed tax system, but these could easily be eliminated by making the tax code inflation-neutral. Indeed, the evidence suggested that an inflation rate of around 4 percent greatly facilitated desirable relative wage adjustments.
Central banks had spent many years convincing people that they were committed to the 2% inflation target, and in fact inflation then hovered around that level. The banks feared that if people saw them raise the target to 4%, they would worry about further increases and the investment in credibility would be lost. So the proposal was going nowhere.
Where are things today?
On the one hand, the relevance of the zero lower bound has become terribly obvious to all of us. Since the start of 2010, the U.S. policy rate has been at the lower limit of effective zero for 95 out of 155 months and, until recent increases, it has been at the lower limit almost all the time in the euro area as well as in Japan.
Admittedly, central banks have resorted to other tools, from slightly negative nominal rates to quantitative easing, but these have a limited impact, are complicated to use and have unfavorable collateral effects. This clearly strengthened the case for a higher target and, by implication, higher average nominal rates and a lower probability of hitting the zero lower bound again.
On the other hand, I became more open to another argument, based on salience. When inflation is low, people and businesses simply don’t think about it and therefore don’t react to it. This was certainly the case before the Covid. When it rises, however, inflation becomes salient, wage and price decisions become more sensitive to it, and inflation expectations become unanchored more easily. All of this makes the job of monetary policy much more difficult.
The question is what rate of inflation leads to salience. A clue is given in a recent article, which examines Google’s searches for “inflation” in terms of the actual rate of inflation. He found that, for the United States, if inflation was around 3-4%, people just didn’t pay attention. Above 3-4 percent they did.
Altogether, these arguments have led me to conclude that, while a higher inflation target is desirable, the right target for advanced economies such as the United States might be closer to 3% than our original proposal. of 4 %.
Will it happen? In 2010, central banks feared they would lose credibility if they raised the target, and in doing so allowed inflation to rise from the then 2% rate. It is certainly not where we are today. Central banks will approach the target from above rather than from below. It makes a difference.
I suspect that when, in 2023 or 2024, inflation comes back down to 3%, there will be intense debate about whether it is worth bringing it down to 2% if it comes at the cost of another substantial slowdown in activity. I’d be surprised if central banks officially move the target, but they might decide to stay higher than it for a while and maybe, eventually, revise it. We will see.