Why central banks should forget about 2% inflation | Jeffrey Frankel | Business

TThe Federal Reserve has reasons to cut interest rates at its meeting on July 31, or later if the US economy weakens. (It is also desirable to keep rates stable if growth remains as strong as it has been in the previous year.) But an argument for easing is less convincing: an imperative perceived for US inflation to reach or exceed 2%.

The Fed set the 2% inflation target in January 2012 under former president Ben Bernanke, after other central banks have already done so. Japan followed suit a year later, shortly after Prime Minister Shinzo Abe returned to power, convinced that monetary policy would increase inflation (Japan had already suffered from falling prices).

The logic was impeccable. With the unemployment rate still high and growth still low in the aftermath of the 2008 global financial crisis, additional stimulus measures were needed. But central banks had already lowered nominal interest rates to zero and could not reduce them further. Monetary policy makers have therefore tried to stimulate economic activity by raising expected inflation.

An increase in the expected inflation rate would reduce the real interest rate (the nominal interest rate minus the expected inflation). And by making the loan cheaper in real terms, central banks hoped to persuade households and businesses to buy more cars, buildings and equipment.

Monetary authorities have taken several measures to reinforce the inflationary expectations of the public. They stressed their inflation goal of 2% or more; were sincere in doing so; and kept the foot on the monetary accelerator (via quantitative easing) as long as inflation remained below the target. In doing so, central banks have multiplied their monetary bases. It's hard to see what they could have done more.

Did it work? On the one hand, inflation remains below 2% in the United States, Japan and the euro area. Month after month, year after year, the authorities had to explain that achieving the goal would take a little longer.

Meanwhile, however, the US and Japan economies returned to full employment by 2016. The US unemployment rate has now fallen to 3.7%, its lowest level since 1969, while the unemployment rate in Japan was 2.4%, against more than 5% in 2010. It is therefore time to declare victory on this front. The main objective of the plan has been achieved, although the envisaged mechanism has largely failed.

Most economists and central bankers however fear for their credibility and remain focused on the need to achieve the 2% inflation goal. In fact, some economists even want to increase the goal from 2% to 4%. A popular proposal among monetary economists is what is known as price-level targeting, in which the Fed is committed to achieving future inflation of 1%. above the target of 2% for each year it is already below that target.

But why should these more ambitious inflation targets be credible or achievable when policymakers have not even managed to reach the 2% target? Economists should instead ask themselves why the standard measures of inflationary expectations, such as occupational forecasts, have not increased much in recent years.

Perhaps the inflation expected by the public – the central element of economists' models for half a century – does not really exist. Or, to be more precise, it may not be well defined when prices are relatively stable. After all, most people pay little attention to the rate of inflation when price growth is as low as it has been in recent years.

In a recent article, Olivier Coibion, Yuri Gorodnichenko, Saten Kumar and Mathieu Pedemonte argue that households and businesses generally do not expect future inflation and often do not know what the inflation rate has been in recent years. . According to the authors, announcements of policy change in the United States, the United Kingdom and the euro area appear to have only limited effects on household and business inflation expectations.

They point out that the expected rate of inflation of US households has averaged 3.5% since the early 2000s – well above the actual rate or forecasts. In addition, when they asked hundreds of senior executives their US consumption inflation forecasts over the next 12 months, about 55% responded that they did not know . Among those who proposed an inflation forecast, the 3.7% average was still too high.

In addition, studies in Germany, other euro area countries and New Zealand indicate that public expectations of inflation are also irrelevant in other regions. At the same time, the authors explain, some conventional surveys of public inflation expectations can produce reasonably misleading forecasts by "priming" respondents into a set of choices.

Former Fed Chairman Alan Greenspan has already defined price stability as "the state in which expected changes in the general price level do not effectively change the decisions of firms and households". In other words, inflation is low enough for people not to think about it. everyday life. In the current context, policy makers should not worry too much if the average citizen does not have well-informed inflation expectations.

Why, then, should central bankers continue to bang against the wall of the desired inflation rate? Of course, monetary authorities should be transparent about their expectations for long-term inflation, real GDP growth and unemployment. Rather than doubling their often-forgotten 2% target, the Fed and other central banks may have to stop serenely pursuing it aggressively.

• Jeffrey Frankel is a professor at the Kennedy School of Government at Harvard University. He was a member of President Bill Clinton's Council of Economic Advisers.

© Project Syndicate