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Business News/ Opinion / Columns/  A higher Fed inflation aim could unsettle America and the world
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A higher Fed inflation aim could unsettle America and the world

A debate has ensued in recent weeks in academic and media circuits over a proposal that argues for a move toward a higher inflation target for the United States

The US economy is likely to grow at an average rate of around 2% during this decade (Photo: AP)Premium
The US economy is likely to grow at an average rate of around 2% during this decade (Photo: AP)

A debate has ensued in recent weeks in academic and media circuits over a proposal that argues for a move toward a higher inflation target for the United States.

Two central issues remain largely neglected in this debate so far. First, a higher inflation target without higher potential growth may itself create an economic-downturn trap that the proposed solution seeks to avoid. Second, inflation targets that are similar in magnitude across developed and developing countries may have significant implications for international financial markets and capital flows.

Let us first understand the background of the proposal.

Olivier Blanchard, a highly regarded macroeconomist and former chief economist of the International Monetary Fund (IMF), recently argued for an upward revision of the Federal Reserve’s inflation target. He made a case for the US central bank to target 3% inflation as against the current stated target of 2% (on average). A decade ago, in 2010, in an IMF working paper, he, along with Giovanni Dell’Ariccia and Paolo Mauro, had argued for the first time for a 4% inflation target for the US (bit.ly/3G3VFqE).

The rationale behind Blanchard’s proposal is that a higher inflation target implies a higher nominal interest rate regime. It would allow more room to lower interest rates during economic downturns, easing the constraints on monetary policy arising from the zero-bound on nominal interest rates. Proponents of this policy shift also argue that 3-4% inflation would not harm the US economy significantly.

But what does an inflation target higher than the expected real gross domestic product (GDP) growth rate mean for an economy?

The US economy is likely to grow at an average rate of around 2% during this decade. Real growth lower than its inflation rate target would imply a sluggish economy that is struggling to generate enough demand. Among the world’s developed countries, between 2010 and 2019, all major economies saw real growth higher or similar to their respective inflation targets.

The Euro area and Japan are the only cases where real growth between 2010 and 2019 may be considered somewhat lower than their respective inflation targets. But this too is not true technically. The European and Japanese central banks have an inflation target of less than 2%. While the Euro area recorded real growth of 1.3% during 2010-19, the Japanese economy grew by 1.2%.

Sustained higher inflation relative to real growth are symptoms of an economy perpetually fighting an economic downturn. Would it be prudent to consciously move towards creating such an economic environment without considering if the trend growth rate in the US can be raised?

The proponents of a higher inflation target for the US should make a convincing case for a combination of a higher potential real growth and higher inflation, not a higher inflation target alone.

As the American economist Tyler Cowen argued a few days ago in a Bloomberg opinion article, while a higher inflation target may make it easier to fight a recession, it may harm workers by lowering real wage growth (bloom.bg/3FGjUtB). Lower real wage growth and higher inflation may lead an economy into a spiralling economic downturn, the precise situation that adopting a higher inflation target aims to fight.

Another issue yet to be discussed in the debate over the US moving to a higher inflation target is the international implications of such a shift, especially for developing countries. India targets inflation at 4% (+/-2%) and Indonesia has a target of 2-4%, while Thailand’s target is 1-3%.

Currently, we are in a rare phase where inflation in developed countries is higher than in developing countries. Traditionally, developing economies have been growing faster than developed economies, as they catch up with the latter in terms of prosperity. In turn, they are the ones that also witness higher inflation than their developed counterparts and target somewhat higher inflation as well.

If the US moves to a higher inflation target of 3-4%, then it would be similar to the inflation target of several developing countries. This would mean that nominal and real interest rates in the US and these developing countries would be similar should respective central banks achieve their inflation targets.

What would this mean for financial markets and international capital flows? Would developing countries, which typically offer a rate premium, lose out on international debt flows if their real interest rates are similar to the US?

But developing countries, at least some of the better placed ones, are likely to grow faster than the US. If so, would more capital flow into their equity markets from debt markets where the real returns may be too similar? How would this affect the volatility of international capital flows?

Issues such as these need further discussion and clarity before any move to a higher inflation target by the Federal Reserve can be considered an appropriate policy shift.

Praveen Kumar contributed to this article.

Vidya Mahambare is a professor of economics at Great Lakes Institute of Management, Chennai.

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Published: 19 Dec 2022, 10:44 PM IST
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