Paradoxically, policymakers are toying with the idea of tweaking up the inflation target for the industrialised economies though most central banks have consistently fallen short of the current 2% rate in the last 10 years.
Underlying the search for an alternative is a concern that the prolonged sub-zero interest rate scenario following the financial crisis could herald a new normal in monetary policy.
The Basel-based Bank for International Settlements (BIS) is the most recent to sound a note of caution. Its annual report points to the risks to financial stability from low inflation and the consequent asset price bubbles, unless central banks moved away from their persistence with ultra-low cost of lending. Unsurprisingly, the debate is especially live in the U.S., which officially adopted the target as recently as in 2012 and where opposition has been mounting ever since.
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The Chair of the Federal Reserve Janet Yellen, after the interest rate rise in June, declared the question of resetting the inflation goal to be critical in policy circles. For long sceptical of the 2% target, Ms. Yellen might well have repeated her prescient 1996 diagnosis that a higher inflation rate would allow the Fed some additional room to stimulate the economy during a downturn. A letter to the Federal Reserve by U.S. economists — including Nobel Laureate Joseph Stiglitz and former Minnesota Fed president Narayana Kocherlakota — last month had also called for an upward revision. The signatories claimed that there was no evidence to infer that a moderate increase in inflation would imply a lower standard of living for Americans and, conversely, that there was proof that a tighter labour market would improve the general conditions.
But the clearest sign yet of the cracks developing in the consensus around the current fixed target is an implicit suggestion by the Federal Open Market Committee of a flexible approach on the question. The FOMC, which had originally set the 2% target in 2012, has held for several months now that its emphasis on inflation is “symmetric”, implying a temporary acceptance of deviations from the official goal. The strong opinion in the U.S. favouring a rethink would suggest that the Canadian approach of a periodic appraisal may be the way forward.
Across the Pacific, when the Bank of Japan embarked upon a monetary easing in 2013, the outlook was to hit the inflation target within two years. It has since deferred the aim twice; the current objective is to meet a late 2017 deadline. Sweden’s Riksbank, the world’s oldest central bank, which holds interest rates at a record -0.5%, said in May that it would soon implement a flexible variation of the strict 2% inflation norm. Opposition is also strong among several of Europe’s pension funds, with low interest rates having a knock-down effect on their earnings. But the 19-nation eurozone, with the Nazi-era memories associated with the need for close monitoring of price stability, is unlikely to flinch from the mandate of close to but below the 2% inflation target.
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