Time for an inflation rethink?

Has the time come for central bankers to rethink their policy goals for inflation? In the Wall Street Journal earlier this week, David Harrison writes that just such a reconsideration may be afoot. With the Federal Reserve’s preferred measure of inflation bumping over the central bank’s 2 percent target in February, now seems as good a time as any to think about what level of inflation is necessary and proper in today’s economy. The central bank consensus around low and stable inflation was forged in a different time, and a rethink for our current situation should be welcome.

Harrison’s article mentions a new paper by economists Michael T. Kiley and John M. Roberts of the Board of Governors of the Federal Reserve system. The paper, recently released by the Brookings Institution, serves as a good jumping off point for why central banks should be thinking about their inflation goals. It looks at the conduct of monetary policy in a world where the interest rate that gets the U.S. economy to full employment and also hits the central bank’s inflation target (the natural rate of interest) is quite low.

Kiley and Roberts build a model of the U.S. economy where, given an inflation-adjusted natural rate of interest of 1 percent, monetary policy hits the zero lower bound quite often. Monetary policy gets “constrained” (can’t do more to boost economic growth) about 40 percent of the time in their model, compared to more than half that rate in other models. (Other models had assumed central banks would be ultra loose with monetary policy and that monetary policy could be constrained for only up to 4 years.) In the model, given the low natural rate of interest and a 2 percent inflation target, the central bank can’t get interest rates low enough to give the economy the full amount of stimulus it needs.

There’s one straightforward solution to this problem: Central banks can increase their inflation target. If the Federal Reserve increased its target to, say, 4 percent, then it would reduce the bind on monetary policy. The concerns about raising the target are due to the potential longer-term costs of higher inflation—though some of those costs may not be as large as many think. Remember that the Federal Reserve’s mandate is to keep prices stable. The 2 percent target, officially declared five years ago, is a choice the central bank made for itself.

But if monetary policymakers don’t want to increase their inflation target, then they might want to make it more flexible. In Kiley and Roberts’s model, hitting a 2 percent inflation target over the long term requires letting inflation rise higher than 2 percent at times. In their model, inflation ideally would need to run at about 3 percent when monetary policy wasn’t constrained. In other words, to get to 2 percent over the long run, central banks would need 3 percent inflation during good times to make up for below 2 percent inflation in bad times.

If this idea of overshooting in the good times sounds familiar, that’s because it’s at the heart of policies that would target either the level of prices or the nominal output of the economy. Kiley and Roberts describe a rule for the Federal Reserve that would have policymakers hold interest rates low until their estimate of the short-term natural rate matches the current rate. But as John Williams, president of the Federal Reserve Bank of San Francisco, points out, price-level targeting and nominal GDP targeting rules would deliver similar results.

Whether an increase in the targeted inflation rate or a change to targeting the level is needed, a change in thinking about inflation seems warranted. In a world of low interest rates, the price of not doing so may be too high.