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Why Higher Future Inflation Rates Are a Bad Idea

Marius Gustavson
March 25, 2010, 4:17pm

During the last two decades the monetary policy regimes of most industrial countries have been based on the idea of “inflation targeting,” including the U.S. (though the target here is implicit rather than formalized by Congress). By aiming at 2 percent year-on-year rise in consumer prices it was believed that economic stability would be attained. Underneath the surface, however, serious financial imbalances were building up due in large part to historically low interest rates. Several economists have thus pointed to easy money as a main cause of the recent financial crisis.

Not so the Chief Economist of the International Monetary Fund and the leading New Keynesian textbook author of our time, Olivier Blanchard. In a recently published IMF policy paper he proposes to revise the inflation targets of central banks upwards. As he stated in a Wall Street Journal interview:

“If I were to choose inflation target today, I'd strongly argue for 4%.”

The reasoning behind this policy prescription, is that a higher inflation rate would ensure a higher nominal policy rate for the Fed and other central banks, thus enabling them to cut interest rates even more, in percentage points, should a new crisis occur. In other words, Blanchard’s “solution” to future crises is even more monetary stimulus.

Inflation hawk and former Fed Chairman Paul Volcker, who is acclaimed for putting an end to the ”Great Inflation”  of the 1970s and early 80s, had this to say about the proposal: ”That is simply nonsense”

In a recent article I comment upon this proposal, showing how such a policy would only exacerbate future financial bubbles:

“If such a policy goal was in place during the boom years of the 2000s, it would mean that real interest rates — which were already negative for more than two years — would have been even lower, borrowing money would have been even cheaper, credit growth even more rapid, and asset prices appreciating at even-faster rates. In other words, monetary policy would have amplified both the boom and the bust to an even larger degree than what we just experienced.”

My case is that the current monetary policy regime based on inflation targeting should be revised:

“This myopic focus on ‘price stability,’ or more precisely, moderate and constant year-on-year growth in consumer prices, made policymakers blind to other possible pitfalls, such as the surge in credit and the rapid growth in asset prices, and the concomitant misallocation of resources led on by distorted price signals. According to the mainstream view, stable consumer prices were tantamount to a stable economy”

Inflation targeting must necessarily lead to asset bubbles in times characterized by strong growth and rapid globalization, as these productivity gains put downward pressures on prices, luring the central bank into ever more expansionary policies:

“The current monetary-policy regime ensures that the better things are going in the economy, both domestically and globally, the more likely is an asset boom and bust.”

The full article can be read here.



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