Inflation Targeting Pros and Cons

Since the 1970s inflation targeting has become widely adopted by developed economies. Inflation targeting means Central Banks are responsible for using monetary policy to keep inflation close to the agreed level.   Inflation targets were introduced to help reduce inflation expectations and help avoid high inflation which can destablise an economy. However, since the recession of 2008 and consequent prolonged unemployment, people have begun to question the importance attached to inflation target and are worried that a ‘religious’ commitment to low inflation is conflicting with other more important macro economic objectives.

Inflation Targets

  • UK The Bank of England have an inflation target of CPI = 2% +/-1. They also have a remit to consider wider macro economic issues such as output and unemployment
  • The ECB have a target to keep inflation below, but close to, 2%
  • The US Federal Reserve have a dual target to keep long term inflation at 2% and maximise employment

Benefits of Inflation Targets

  1. Credibility / Expectations. If an independent Central Bank makes a commitment to keep inflation at 2%, people will tend to have low inflation expectations. This makes it easier to keep inflation low. If there was no inflation target, people could have higher inflation expectations, encouraging workers to demand higher wages and firms to put up prices. An inflation target makes it easier to keep inflation low.
  2. Avoid Boom and Bust. The UK economy, in particular, suffered from many boom and bust economic cycles. We had a period of high inflationary growth, which later proved unsustainable and led to a recession. By keeping inflation low, we avoid boom and bust cycles like the late 1980s boom.
  3. Costs of Inflation. If inflation creeps up, then it can cause various economic costs such as uncertainty leading to lower investment, loss of international competitiveness and reduced value of savings. See: Costs of inflation for more details

Problems with Inflation Targets

  1. Cost-push inflation may cause a temporary blip in inflation. Just before the recession of 2009, the UK experienced cost push inflation of 5% due to high oil prices. To target 2% inflation, would have required higher interest rates, which leads to lower growth.
  • To some extent the UK and US are willing to tolerate temporary deviations from the inflation target. The Bank of England has allowed inflation to be above target during 2009-2012 because it felt inflation was temporary and the recession was more serious.
  • However, the ECB have shown greater inflexibility and unwillingness to tolerate temporary blips in inflation. For example, in 2011 the ECB increased interest rates, despite low growth.

2. Central Banks Start to Ignore More Pressing Problems. The ECB is setting monetary policy to keep inflation in the Eurozone on target. Yet, the ECB seems unwilling to act on the significant increase in unemployment. The ECB seem remarkably unconcerned about the Eurozone’s slide into a double dip recession. Rather than trying to prevent a prolonged slump, they are fixated on the importance of low inflation.

Inflation above target can impose costs on the economy such as uncertainty, loss of competitiveness and menu costs, but arguably these costs are much less significant than the social and economic costs of mass unemployment. Unemployment in Spain has reached 25%, but there is no monetary stimulus in the Eurozone because the ECB is worried of inflation at 2.6% – This is giving low inflation too much priority in times of a recession.

3. Sometimes you need a higher inflation rate. This point is controversial, but many argue that it would be beneficial for Germany to have higher consumer spending and higher inflation.

In the Eurozone, Germany has a current account surplus of 6%. Southern European countries have a large current account deficit and loss of competitiveness. To restore competitiveness, Southern European countries are pursuing deflationary policies which are risking recession and deflation. If Germany had higher consumer spending and higher inflation, then this would make the readjustment process in the Eurozone less painful.

4. Inflation Targets are limited. After the 1992 recession, the UK had a long period of economic expansion and low inflation. This suggested inflation targeting was very successful in avoiding inflationary booms. To some extent this was true. However, the low inflation disguised an asset and banking boom and bust. This isn’t so much a criticism of inflation targeting, but it is a clear limitation. Low inflation doesn’t mean the economy has an underlying stability.

5. A large output gap doesn’t necessarily lead to deflation. An IMF paper shows that countries with a large negative output gap often don’t see a fall in inflation. Therefore, targeting inflation alone can lead to a suboptimal response. (Dual mandate at Fed)

6. Which inflation measure to use? There can be a significant different between RPI and CPI. Also, even CPI can be greater than underlying inflation which excludes volatile prices, such as energy and food. See: Different measures of inflation

Conclusion

Inflation targets can have various benefits, especially during ‘normal’ economic circumstances. However, the prolonged recession since the credit crunch of 2008 has severely tested the usefulness of inflation targets. There is a danger that Central Banks give too much weighting to low inflation, when there is a much more serious economic and social problem of unemployment.

One solution would be to give an equal weighting to an inflation target and output gap target. The UK and US do actually have this dual target, though the inflation target often seems to be given the highest importance.

My biggest criticism rests with the ECB (which has only a single mandate for low inflation). They seem to give the impression of under-estimating the economic cost of prolonged unemployment and a persistent output gap in the Eurozone. Furthermore given the structural problems of the Eurozone, it is even more important to have flexibility in the inflation target within the Eurozone.

The ECB say that if they change their inflation targeting, they will lose credibility. But, why don’t they feel a lose of credibility in allowing a double dip recession and persistent rise in unemployment? – That is the real threat to Europe, not a minor increase in the inflation rate.

I have nothing against inflation target, if the Central Bank gives as much importance to the dual target of unemployment / output gap. Also in exceptional times – liquidity trap / recession – there needs to be more flexibility on inflation – even at risk of the Central Banks precious ‘inflation credibility’