Tim Harford’s FT article responds to the recent ebook on secular stagnation – the tendency for weak demand to depress equilibrium real interest rates – circulated by VoxEU. He deduces that raising the inflation target would help combat or avoid it.
Well – at least through the lens of modern macro – yes and no. First, raising the inflation target now might well not help at all. With the reliable and conventional tool of interest rates at their zero floor, and fiscal room for stimulus argued by some to be minimal, or at least politically limited by those with this view, there would be no means to achieve a higher inflation target. At least, if you are sceptical that QE has any great effect beyond signalling the future path of central bank rates. [A view held by Barro, Sims, Woodford, Cochrane and many others, though one that is controversial.] If this was the case, raising the inflation target could be self-defeating, since it would set up the central bank to fail, and the credibility of monetary and other public macroeconomic policies could suffer as a result.
In this sense, raising the inflation target is something we should consider as a step to take to reduce the probability of interest rates having to hit the zero bound again in the future, ie as a preventative measure, rather than a cure for future ills.
Note too that as a preventative measure it won’t entirely eliminate the bad consequences of secular stagnation. In the long run monetary policy can’t do this. As Tim notes in his post, low equilibrium real rates are ultimately determined by supply and demand. Higher inflation will lead to longer time higher levels of the central bank rate, making more room for larger interest rate cuts, and, repeat, making it less likely that policy gets trapped again at the ZLB and the real side of the economy suffers from the recessionary traps associated with being stuck there. But long run higher inflation won’t – a few minor details glossed over – do anything to raise long term growth or equilibrium real rates.
So, in sum, higher inflation isn’t a good cure for today’s ills, and would only be a partial solution to the unattractive features of longer run secular stagnation. I’m personally in favour of raising the target at some point. Indeed, as I blogged before, I’ve urged that we consider setting up a body to conduct low-frequency reviews of the appropriate inflation target, to respond to low-frequency changes in real rates. But not now. And we shouldn’t hope for too much for it, and not lightly dismiss the costs associated with it in potentially unhinging expectations of nominal stability.