With the fight against inflation still a looming backdrop for central banks, the decline in recent months had eased market jitters, although in the eurozone, the consumer price index rebounded in May to 2.6% (two decimals above the previous month), while in the United States it reached 3.4% at the end of April, the latest figure available. However, central bankers still have the hardest and most challenging job ahead of them, namely to stabilise inflation at 2% without triggering recessions in their respective economies, which are already starting to slow down, particularly in Europe.
In view of the above, a potential rate cut, greater inflationary pressures resulting from China and the United States imposing tariffs, higher energy prices due to technological development (data centres will use 8% of US energy in 2030, set against 3% in 2022) and expansionary fiscal policies are reopening an old debate among economic currents: how high should they set the inflation target?
No economic study has convincingly determined what the optimal inflation rate is. However, many central banks have opted for a common policy, with an inflation target of around 2%. These central banks include the Federal Reserve (which regards 2% inflation as a “long-term objective”), the European Central Bank (which aspires to inflation rates “below, but close to, 2%”) and most other central banks in the advanced economies. But is there a case for raising such a target?
The main reason for raising the inflation objectives would be to prevent the so-called Zero Lower Bound. This is a macroeconomic crossroads that occurs when short-term nominal interest rates lie close to zero or at zero. A liquidity trap is thus created, undermining the central banks’ ability to stimulate the economy.
Many economists have pointed out that the liquidity trap makes no practical sense, as nominal interest rates tend to be above zero prior to and during recessions. In a recessionary environment, this enables the authorities to cut interest rates with sufficient room to restore full employment, without reaching the zero threshold. In 1990, the turning point came when Japan, mired in a recession, saw how its Central Bank cut interest rates from 6% in 1992 to 0.1% in 1999. However, output and activity remained low, plunging the country into the so-called liquidity trap, a situation similar to that experienced by the United States and Europe in the wake of the 2008 financial crisis.
With the central banks unable to cut interest rates any further, unemployment rose and remained high throughout a large part of the last decade. In response, the central banks came up with “quantitative easing”, a formula consisting of the expansion of the monetary base by means of large asset purchases.
The risk of reaching the Zero Lower Bound of interest rates thus depends on the inflation target set by the central banks. To illustrate this concept, let’s assume that an economy begins in long-run equilibrium with a specific inflation target and level of long-term real interest. This means that the long-term level of the nominal interest rate will be the sum total of the two percentages.
We can illustrate the above with two scenarios in which a recession hits a country, with different inflation targets. In the first scenario, the country has a 2% inflation target and a 2% long-term real interest rate. The central bank could lower this nominal rate by up to four points before it reaches zero.
Conversely, in the second scenario, in which the inflation target is 4% and the long-term real interest rate remains at 2%, the central bank could lower the nominal rate by up to six points before falling into the liquidity trap.
In any event, an inflation target above 2% has not always been rejected by central bankers. Under Volcker’s tenure, the Federal Reserve managed to stem the double-digit inflation recorded in 1970; this was an episode that was coined “the conquest of inflation”, with inflation levels remaining stable at 4% from 1985 to 1988 and no attempt by Volcker and the other members of the Federal Reserve to reduce it. The Federal Reserve didn’t tighten its policy until late 1988, when inflation began to rise again.
Nevertheless, inflation remains a phenomenon that destroys purchasing power from which ordinary citizens cannot escape. The high level of inflation in the 1970s was an experience that has dominated the thinking and actions of central bankers ever since. They have thus set themselves up as guarantors to ensure that no such destruction can recur and maintain stability over time.
Similarly, this inflation target appears unlikely to change in the short to mid term, given that, in addition to their monetary policies, the central banks’ most important tool is communication. Changing this objective would discredit the narrative of the governors and their monetary measures.
Published in Invertia / El Español 05.06.2024