The International Monetary Fund’s (IMF) chief economist, Olivier Blanchard, recently published a paper (“Rethinking Macroeconomic Policy”) that attempts to distil preliminary lessons from the financial crisis. The paper contains much that is useful and worthy of further consideration—but it also suggests that central banks should aim for higher inflation during normal times, say 4%.
Such an inflation target, the argument goes, would lead to higher nominal interest rates and, therefore, give more room for monetary policy to be eased during times of crisis. This argument is severely flawed and its timing highly unfortunate, if not imprudent.
The basic assumption behind the suggestion of a higher target inflation rate is simply wrong. As the recent crisis has vividly illustrated, monetary policy is not powerless once the short-term interest rate is close to zero. The Bundesbank and the Swiss National Bank have argued for some time that short-term interest rates are not the only means by which monetary policy affects the economy. “Unconventional” measures such as longer-term refinancing opportunities, liquidity facilities and asset purchases have been effective in further stimulating the economy.
There is little reason to believe that having a few additional percentage points to cut short-term interest rates would have been more effective. In short, an interest rate of zero is less of a problem for monetary policymaking than Blanchard and his co-authors assume. The alleged potential benefit of higher inflation for macroeconomic stability is, therefore, grossly overstated.
More importantly, a higher inflation target comes with severe macroeconomic costs. First and foremost, it would greatly undermine macroeconomic stability by raising inflation expectations.
It is an illusion to believe that central banks could engineer the transition to a substantially higher level of inflation without risking the credibility they have built up over the past decades. Assume central banks were to aim for 4% inflation rather than 2% after this crisis. Why should the public not fear further slippage after the next crisis? Both the Swiss and the German central banks have been front-runners in promoting credible policies geared at maintaining price stability. These experiences must not be sacrificed for ill-founded, short-term considerations.
There is a strong case for central banks to commit to price stability rather than aiming for higher inflation as proposed by Blanchard. Price stability is a crucial public good—crucial for economic growth and prosperity, and also for social stability. This is a lesson from history of which the citizens of our respective countries are deeply aware. Moreover, the weakest members of society typically suffer the most from inflation because they have only limited possibilities to protect themselves against it.
In the current environment of high fiscal deficits and rising public debt, it is particularly important that central banks make a credible commitment to price stability. Adding to public concerns about inflation risks in the current environment is dangerous. Suggestions from the IMF chief economist that central banks should aim for higher inflation could be misinterpreted as a signal that central banks are being roped into devaluing government debt through inflation.
The public’s understanding of, and trust in, central banks and their commitment to price stability is essential for the ongoing effectiveness of monetary policy. Eroding central bank credibility through higher inflation targets does not contribute to improving macroeconomic stability. Nor does it equip policymakers against future shocks. Quite the contrary.
The Wall Street Journal
Edited excerpts. Axel Weber is president of the Deutsche Bundesbank and Philipp Hildebrand is chairman of the governing board of the Swiss National Bank. Comments are welcome at firstname.lastname@example.org