Central Bank: What Inflation Rate Is the Right One

The Federal Reserve doubled down on its aggressive approach to handling inflation despite early signs the U.S. economy is starting to slow down and raised its benchmark policy rate by 75 bps (2.25–2.50% per annum) for the second month in a row.

And there’s more to come. Most analysts expect short-term rates to rise by another percentage point by the end of the year. After that, the interest rate will hit more than 3%, compared to 0% at the beginning of March.

We can’t wait to see inflation on August 10, which is now far from the target level of 2%. The Economist announced that it would be harder to determine what low but the positive inflation rate is desirable.

Is the target level of 2% better than 3–4%? Or does it simply follow a common tradition when «2%» is the first official rate adopted by New Zealand? This tradition started with the «unscientific» remark made by the Minister of Finance of New Zealand in 1988, who suggested that the soon-to-be independent Central Bank should aim for 0 or 1% inflation.

The Central Bank used this level as a starting point and stopped at 0–2%. Over time, «2%» turned out to be the standard throughout the rich world. Essentially, it depends on opinions.

Does the somewhat arbitrary level of 2% need to get changed? This question seems out of place since the Central Bank is far from achieving its goals: inflation in the U.S., the UK, and the EZ has reached ~ 9%. The Fed’s experiment with «flexible average-inflation targeting» has coincided with the Central Bank allowing inflation to spiral out of control. Yet it’s possible that raising the target could help prevent rich countries from returning to the low inflation and low growth that was the rule for the decade after the global financial crisis.

High inflation is painful. Even if salaries keep pace with rising prices, thereby maintaining workers’ incomes in real terms, it undermines the function of money as a unit of account and as a store of value. Contracts quickly lose their value, arbitrarily redistributing incomes between buyers and sellers or between creditors and debtors. Long-term investment and savings decisions become unpredictable, as the case of Turkey, where inflation is ~78%, proves.

Deflation is painful, too. Both mortgage holders and governments are suffering. It raises the value of debts in real terms, which can trigger a self-sustaining depression as incomes continue falling relative to debt repayments. That explains why central banks aim for low but positive inflation.

If the costs of a slightly higher inflation target aren’t significant, the benefits are potentially sizeable. First and foremost, it could help the Central Bank to avoid the so-called zero lower bound on nominal interest rates. Interest rates can’t be super negative because they risk destabilizing the banking system: depositors can always opt to close their bank accounts and hold cash, which carries an interest rate of zero.

Higher inflation targets are a different solution to the problem of the lower bound. If the Central Bank is expected to generate more inflation in the future, the interest rate, in real terms, could be sharply negative, stimulating the economy even without the need to take nominal interest rates below zero. Generating moderately higher inflation in normal times can make it easier for the Central Bank to boost the economy in crisis times.

The chance to go beyond the lower bound on interest rates is no small thing. Despite the monetary-policy tightening, the risk remains that interest rates will stay relatively low. The long-term factors that affected interest rates before the pandemic, such as an aging population and low productivity growth, are still in place.

The damage caused by high or accelerating price surges is still visible. But economists are now trying to determine how different inflation rates—stable, low, high, or single-digit—affect the economy. The recent 20-year period of very low inflation brought neither a positive lead forward in productivity nor a change in savings behavior, except in response to the global financial crisis.