The problems with raising the inflation target to 4%

One of the features of the economic environment is how monetary policy easing options are like weeds in a garden. As soon as you chop them down it feels like a new batch appears. This is particularly true of my subject of today which is that there has been a recent flurry of articles and suggestions that the inflation target should be raised usually to 4% per annum. This would replace the current level of 2% used by most of the world’s central banks. This is a situation which was aptly described by The Average White Band.

Let’s go ’round again
Maybe we’ll turn back the hands of time
Let’s go ’round again
One more time

Before we move onto the details of this I would like readers to stop and think exactly how an increase in inflation would help them? A faster rise in prices just on its own would make consumers and workers worse off. After all if inflation was an economic cure why did countries in the 1970s and 80s go to so much trouble to push it lower?

The theory

A paper has been published on the Voxeu website by Paul De Grauwe and Yuemei Ji and the essentials of the case made are shown below.

An inflation target too close to zero risks pushing the economy into a negative inflation territory when even mild shocks occur. During periods of deflation the nominal interest rate is likely to hit the lower zero bound (ZLB). When this happens, the real interest rate cannot decline further. In such a scenario, the central bank loses its capacity to stimulate the economy in a recession, thereby risking prolonging recessions that do occur.

Okay let me respond sentence by sentence. Firstly we have the implication that negative inflation is bad when we have seen that via a boost to real wages it can expand consumption in an economy. I first discussed this back in January 2015 with respect to the UK, Ireland and Spain. Also there is the issue that for many years high inflation and not low inflation was the problem so the proposed solution may well be dealing with a symptom rather than a cause.

The next sentence was presumably updated with the word “lower” as the authors would have been using 0% as the lower bound until a couple of years ago. With so many countries now having negative interest-rates ch-ch-changes have been required but the concept of a lower bound has seen so much revisionism as it has got well lower and lower. For example the current state of play in the UK allowed Mark Carney to in effect promise Bank Rate below  the 0.5% which he previously called the “lower bound” for it. Mario Draghi has cut the ECB interest-rate to -0.4% below what he called the lower bound. Indeed the Riksbank of Sweden which has the lowest official rate if we look at the deposit rate of -1.25% told us this on Wednesday.

The Executive Board remains highly prepared to make monetary policy even more expansionary, if necessary, even between the ordinary monetary policy meetings. There is still scope to cut the repo rate further.

The repo rate is -0.5% and could be cut without lowering the deposit rate but it’s rhetoric is not one of a central bank which thinks that it is out of ammunition.

The final point of a central bank riding to the rescue in a recession has a problem. It is simply that if it was that simple we would not be where we are. Some 8 years or so into a credit crunch where central banks have fired their phasers repeatedly and run down the supplies of photon torpedoes we apparently still need more! More! More! As Agent Smith put it in the Matrix series of films and of course he lost.

The conclusion of the paper is as follows.

An inflation target in the range of 3% to 4% comes closer to producing a symmetric distribution of the output gap.

Ah the output gap that has been about as much use as a chocolate teapot in the credit crunch era. Also we are told this.

It turns out that an inflation target of 3% or 4% has more credibility than a target of 2%.

How? As central banks currently cannot mostly hit a 2% inflation target surely raising it would be even worse.

Japan as a test case

The Bank of Japan is the central bank which has most set its sights on the policy objective described above. It has just pushed the monetary base to above 400 Trillion Yen ( 403.9 to be precise) which compares to the 358.7 Trillion of January so as you can see it is expanding it very quickly. Yet for some this is still not enough.

With thanks to Mike Bird of the Wall Street Journal here are the thoughts of Credit Suisse.

The case for a 4 per cent inflation target for the BoJ

Okay so how would it be achieved?

We would argue that the central bank has actually  been too disciplined (restrained) in its approach to monetization of government debt. ……… we think it possible for the bank to promise that monetization of government debt will be maintained over a more extended period of time.

I bet some of you thought I was joking with my “To Infinity! And Beyond!” critique provided by Buzz Lightyear. Trapped within this is the fact that we always are told we need more without any objective analysis of why what was previously regarded as “more” is not working. Let me pose some questions for that approach.

  1. This was supposed to provide a lower level for the Yen but in spite of an acceleration in the size of the monetary base the Yen has been appreciating. It is at 100.6 versus a US Dollar which itself has been strong.
  2. We were promised by so many places that wages were just about to turn a corner and places like Bloomberg and the Financial Times have told us it has turned a corner. Last night the Ministry of Labour reported that total wages fell by 0.2% in May compared to a year earlier.

Your typical Japanese worker and consumer will rather doubt the promises of those who tell them that higher inflation will be some sort of economic nirvana after the experience of 3 and a bit years of what was supposed to be that nirvana! In the theories and economic models wages will respond to the higher inflation whereas in the real world that would be against wage trends that have been in play for quite some time. Ivory Tower meets reality you might say. Or as Japan Macro Advisers put it.

After taking account of inflation, real wages rose by 0.2% year on year in May. However, when we consider that real wages in Japan has been declining for many years, the pitiful rise of 0.2% rise offers little consolation. In real terms, real wages are still close to the lowest point in 30 years.

Yep the improvement in real wages came as a result of lower and not higher inflation but our Ivory Tower experts would apparently at the stroke of a pen solve a 30 year problem. Does anyone believe that?


There is an elephant in this particular room and I note that it fails to get a mention in the Ivory Tower theories. It is of course the debt burden which will be inflated away more quickly with 4% inflation than 2% inflation. Debtors rule okay or something like that! Except that the price is very likely to be that workers and consumers will be worse off in real terms just after they have taken a hit anyway. After all when the UK had 5% inflation in the autumn of 2011 there was no compensating surge in wages and in fact real wages were hit hard.

Another issue is the claim that higher inflation targets allow prices to adjust relatively. It is not made in the cases above but no doubt it will be along. Let me help out with some UK data.

The CPI all goods index annual rate is -1.8%, down from -1.6% last month……The CPI all services index annual rate is 2.6%, up from 2.4% last month.

It seems able to have relative price changes with near zero inflation does it not?

The Bank of Canada looked into this and I note that on its way to suggesting a revisiting of the inflation target it told us this.

The main conclusion is that, in the absence of the zero lower bound, the optimal rate of inflation is zero or negative.

Well since their paper was published in October 2015 the zero lower bound is not what it was.





20 thoughts on “The problems with raising the inflation target to 4%

  1. Hi Shaun

    The crux here as I see it is the debt burden which, as you rightly say, cannot fall unless wages respond to inflation, which they have clearly failed to do in recent years. This is the subliminal message that fails to be openly articulated.

    One thing you don’t mention and that is the stealth devaluation of the Yuan. This is an ongoing situation and does of course have consequences for the Yen as well as the rest of the World. It is making a mockery of Abenomics as well as changing the inflation target.

    What the Chinese are doing is exporting their deflation resulting from vast overcapacity to the rest of the World and I can’t see this stopping anytime soon. They have of course denied that the policy is deliberate but, in China, everything is deliberate.

    Changing the inflation target is whistling in the wind; it is yet another pointless turn of the wheel in the face of manifest impotence.

    • Hi Bob J

      I agree completely that the ongoing devaluation of the Yuan would be getting more note if there was no Brexit. From the abandonment of 6.21 to the US Dollar early last August it is now at 6.69 so slip-sliding away as Paul Simon might say. Against the strong Yen it is even more marked as it has moved from 20 Yen per Yuan to 15 now. So those in the Far East who tell us that Brexit is a big deal to them are ignoring the elephant in the room.

  2. This is just more tinkering around the edges and failing to face up to the real issue – namely that monetary easing has merely ramped up asset prices (and the borrowing required to sustain it), while the debt repayments of capital, which ex hypothesi cannot change with int rates, have simply sucked the life out of demand consumption – and so of both GDP and inflation as usually measured by RPI etc.

    I have read several times about “the liquidity trap”, which is usually placed at 0% rates as the point at which the central banks cannot stimulate the economy – precisely because the extra borrowing goes into assets. I have long been of the view that while this might be technically true (and the wage/inflation differential upsets it anyway), the real liquidity trap is at a higher level, depending on the national property market – probably around 4% in the UK, maybe more around the 2.5% level in the euro area, although much depends on credit conditions – UK rates fell from 14% in Jan 1985 to a bottom of 7.5% in May 1988, then the brakes went on hard and we experienced the Lawson boom/bust over this period. A key factor may thus also be the movement itself, rates halving over 3.5 years compares with 7 years of no change at the moment.

    While it may seem attractive to have a higher rate of inflation or interest, sop that there is more room for manoeuvre, this is not addressing the issue. rates need to rise fairly quickly now to collapse the housing market and release funds from savers to stimulate consumption and hence inflation (assuming we work on a demand-pull inflation theory). However, given the issue highlighted in yesterday’s blog, this will not happen.

    • Hi David

      We have an example of the asset boosting game employed by central bankers tonight. The S&P 500 closed within a point of its all-time high tonight and the US 10 year yield closed at an all time low of 1.366%.. The old theory of selling bonds when the equity market rises has been blitzed. As we see all time highs in so many places we see that they are trying to manipulate everything.

      • It’s Micawberism on a grand scale: just kicking the can down the road hoping that “something will turn up” – hence the recent claims that stopping immigration will raise pay for the poorest-paid. It cannot happen now, simply because the low rates mean that the debt repayment is of capital.

  3. Great article as always Shaun.

    At the moment I am a prime example of how inflation (not deflation) postpones purchases. I’ve been looking at buying a pc recently. And since brexit the price of my pc has risen by £100. I’ll be delaying my purchase until it reaches my pricepoint.

    • Hi Anteos and thank you

      I am sorry to have to tell you that the version of HAL 9000 used in Ivory Towers has just blown up. If its price is higher too then our Ivory Tower occupants may have to face the consequences of believing it is good to pay more for things.

    • Hi there in Bulgaria! I think that they will have to print to settle budget deficit since tax raises are off the table since the people have spoken. Now this is very tricky since Sterling is already on a downward trend. I reckon Carney is busy communicating through the Vampire squids tentacles to friends in the US and even China to suport our currency this autumn/winter, they are likely to comply since everybody needs rates to stay low. Of course this will be interesting to see play out.

      Paul C.

      • As a fightback Remainer, I am hoping that the despicable Leadsom gets elected and the currency slide forces the BoE to raise rates – ending in a complete car crash, so we go back in under a new PM.

        I was amused that in tonight’s nonsense about “being a mummy” (an appeal to Daily Mail readers if ever there was one), she has actually said that she did not want a downturn, because of the effect it would have on her kids. We all remember the last politician to claim an end to boom & bust – and where that finished up.

  4. There should be no minimum inflation target, only a maximum one that you cannot exceed. It is a clear admission that most advanced economies are in a liquidity trap (which higher inflation will not address as CB’s will not necessarily raise rates in line with inflation and wages have demonstrated they no longer follow inflation) when the IMF is saying Fiscal policy should be re-examined, this from an organisation which has demonised Fiscal Policy as a stimulus for 30 years only talking about monetary policy as the only tool that can work.

    The only way forward now is to raise interest rates slowly, there is of course a great risk of a bust but it is interesting to observe the experiment the Fed is currently conducting, I am watching them closely to see what can be learned.

    • Hi Noo2

      There was a path where Governor Carney followed his own Forward Guidance. But instead he never even backed it up with one solitary vote.

      As to the IMF I see what it has become with sorrow.

  5. Hi Shaun,, Of course I blame the kiwis for inflation targeting..
    In the 70s and 80s NZ inflation typically ran over 10%. The first target (1990) was 0-2% which was later changed to 2.2-4.5% and by 1992 it was back to 0-2%
    25 years later NZ has inflation running about 1% (from memory) and a high dollar, high household debt and high asset prices; and much like anywhere else (half) the population take comfort from the fact that their property values continually rise and neither the Government nor the RBNZ want to do much about the problem (for the other half) of affordability preferring to blame supply (the builders) and demand (immigration).

    Here’s Brian Gaynor in today’s NZ Herald with some figures.

    • oops – errors and omissions
      In 1991 the target was 2.5 – 4.5%
      The current target is 1 – 3%
      The current inflation rate is 0.4% up from 0.1% – (not 1% from memory)

      • Hi Eric

        If you throw in the All Blacks and Steve Walsh I’m in too! More seriously I note the target was eased and then tightened which is not entirely reassuring for those who want inflation targets eased now.

        Thanks for the link and these bits showed that it is pretty much business the same wherever you are.

        “”Household wealth in New Zealand was concentrated in the 20 per cent of New Zealand households, which held about 70 per cent of total household net worth”.

        “Thus older individuals, with multiple properties and little debt, are in a far better position than renters because of the soaring residential property market. As a consequence, there has been a huge increase in demand for residential property as individuals attempt to maintain their place on the wealth ladder and avoid dropping behind.”

    • There are other ways to fix the housing issue plus transport problems Auckland faces. Drop business tax 2% nationally and hit Auckland employers for congestion charges + regional transport improvement fees. Traffic jams cost and waste time

      • It’s worth saying that Auckland has a housing and traffic congestion crisis – not New Zealand.
        In many parts of the country property values are still well below the level of 10 years ago. As for traffic – I’ve just renewed my annual vehicle licence. The basic fee, ignoring the insurance, admin and tax components, is NZ$43.50

    • Positive nett immigration was once a sign of success. DDR built the wall to prevent people leaving. More democratically Rob Muldoon joked that all the kiwis leaving to Australia ‘raised the IQ of both countries’. According to the Bill & Melinda Gates foundation the percentage of world population in extreme poverty is decreasing fast. So the status quo is better than the past, but should do better on accountability, financial stability and generational equality.

  6. Great blog Shaun as always.

    I apologize if I am repeating myself but I was very impressed by a paper given by Leo Michelis at the 2015 meeting of the Canadian Economics Association of which he was a co-author. The math in it is heavy going but the thrust is simple. The traditional way of measuring the welfare costs of inflation gives much lower costs than it should. Using the method suggested by Mansoorian and Michelis the welfare cost of going from 0% to 10% inflation are about three times as high as using the traditional approach, which dates back to a 1956 paper by Martin Bailey. The main difference is the failure of the traditional approach to account for consumer habits in estimating welfare loss. As you can see, it isn’t really a policy paper, but when I asked Professor Michelis if it had any bearing on the issue of raising the target rate of inflation he responded that it most certainly did. I suspect that De Grauwe and Ji are assuming the much lower welfare costs of a higher inflation rate in the traditional model and not the costs postulated by Mansoorian and Michelis.

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