- Low and stable inflation is good for economies
- But this doesn’t mean we have to aim for 2 per cent
Will inflation ever drop back? The Bank of England thinks so. As my chart shows, it forecasts a rapid retreat, with inflation returning to the 2 per cent target by Q2 2024. But there is another argument: thanks to reduced globalisation, elevated inflation expectations and changing energy supplies, inflation might become ‘structurally’ (and permanently) higher.
UBS analysts addressed this in a recent briefing, but remain sceptical. They argue that “we believe the inflation trend over five to ten years is largely controlled by the central bank” meaning that inflation can remain elevated “if, and only if, central banks allow it to move higher”.
Given the steely rhetoric of central banks over the past few weeks, this seems unlikely. The BoE says that it is prepared to “respond forcefully” to inflation and Fed Chair Powell said that the FOMC remains “strongly committed to bringing inflation back down to our 2 per cent goal”.
But here’s a radical idea - what if they stopped trying?
As the BoE sets out, the desirability of “low and stable inflation” is well established, but a 2 per cent target is relatively arbitrary. Today’s experience reminds us that high inflation is painful: squeezing real incomes and fuelling fears of a wage-price spiral. But very low inflation is also a problem - it risks tipping into deflation, increasing the real value of debts and encouraging people to delay consumption.
A bit of inflation also helps central banks to avoid the ‘zero lower bound’ of interest rates. If interest rates are at zero but the economy is underperforming, traditional monetary policy is stymied: the central bank can’t provide any further stimulus by cutting rates. If policymakers aim for a higher inflation rate, they can set higher nominal interest rates whilst keeping the same ‘real rate’. The higher the inflation rate, the more scope central banks have to cut.
This might seem a rather hypothetical problem. Yet if forecasts are correct, the UK could find itself mired in a low growth and low inflation (see chart) environment relatively soon. A higher inflation target would mean more monetary policy ‘firepower’ if the economy stagnates.
This was the argument made by economist Olivier Blanchard and colleagues in a 2010 IMF paper, which raised another important question: why have a 2 per cent target at all? Are the net costs of inflation really any higher at 4 per cent?
This question has consequences for our immediate economic position, too. The BoE’s Huw Pill recently warned that the economy would not face an “immaculate disinflation”, and that returning to target would mean a weaker economy. The Bank expects unemployment to rise to 6.4 per cent by 2024, and for the UK to enter the longest recession in a century. Does pursuing a 2 per cent target mean economic pain for minimal gain?
Howard Davies, former chair of the Financial Services Authority, argued in August that raising the UK’s inflation target “might give policymakers a little more flexibility, and bring about a more stable monetary-policy regime in the longer term”. But he also highlighted a significant problem - raising the inflation target as price increases are running hot is risky. After all, it could untether inflation expectations.
The Bank’s fragile credibility would also be damaged if the move to a higher target gave the impression of giving up the fight against inflation. It would be particularly vulnerable if it moved first amongst the club of economies with a 2 per cent target, especially the Eurozone and the USA.
Given central bankers’ tough talk, it is hard to imagine any of them settling for anything less (well, more) than target. Yet inflation is forecast to drop swiftly and dramatically. Once it is on a downward path, the dialogue will be free to pivot away from the battle against inflation and towards the monetary policy of the future. A higher target could become an increasingly attractive prospect.
