This 23-minute podcast was released Feb. 19, 2020.
“Economists generally thought and still think that high and volatile inflation has much higher costs than very low and stable inflation,” says Christopher Neely, a vice president in the Research department at the Federal Reserve Bank of St. Louis. He talks with Jennifer Beatty, an assistant vice president at the St. Louis Fed. They discuss the targets set by central banks around the world to control inflation.
Jennifer Beatty: Welcome to Timely Topics, the podcast series hosted by the St. Louis Fed. I’m Jenn Beatty, your host for this episode. Today we’ll be talking with Chris Neely, an economist by trade and a vice president in the Bank’s Research division. Welcome, Chris.
Christopher Neely: Well, thanks very much, Jenn.
Beatty: Today we’re exploring the concept of inflation, specifically the target set by central banks around the world to control inflation. So, as background, Chris, could you just give us the sense of what is inflation? And why are central banks so focused on controlling it?
Neely: Well, central banks are focused on controlling inflation because people don’t like it. And what inflation is, is it’s a rise in the general price level. So, people often talk about inflation in a particular good or category of goods. For instance, inflation and gasoline prices. But really, inflation is a rise in the general price level, not just the rise in the prices of a particular good or subset of goods.
Beatty: So, as you talked about, the average consumer who reads about inflation or higher oil prices, et cetera, might wonder, why does the Fed or any central bank want overall prices and goods to increase?
Neely: Well, that’s a good question. Certainly, there are some economists who think that it would be best if the overall price level were to stay flat indefinitely. But probably more economists believe that there are greater costs associated with a completely flat price level, that is, with no inflation at all, than with a low and stable rate of inflation. Most economists would favor a low and stable rate of inflation over absolutely zero inflation.
Beatty: The central bank is clearly focused on maintaining price stability. But to what degree can monetary policy set by central banks actually influence the rate of inflation?
Neely: Not too long ago, say, before the financial crisis, I think that economists were much more sanguine about the ability of central banks to hit an average rate of inflation over a period of time. That is, they thought that inflation was fully within the ability of central banks to control at least on average over a period. And I think that most economists still basically would agree with that.
But there has been some rethinking on the issue, especially in light of the inability of the Bank of Japan and to a lesser extent, the European Central Bank, and to a lesser extent, the Fed to raise inflation to levels that they would like.
Beatty: Roughly 30 years ago or so, central banks around the world adopted explicit inflation targets. Why did this occur?
Neely: So, the adoption of inflation targets arose from the ashes of the inflation of the 1960s and ’70s, and then the disinflations of the 1980s. So, during the 1960s and ’70s for various reasons, central banks often felt that they couldn’t control inflation or were unwilling to take the steps necessary to control inflation. And so, central banks around the world let inflation get out of control, and inflation rose globally in the ’60s and ’70s.
And central banks had a lot of reasons for why this happened. Chief among them were the rise in oil prices in the, first the mid-’70s, and then the late-’70s and early ’80s. But despite the rise in oil prices, central banks could have controlled inflation had they been willing to do it.
And in the late ’70s and early 1980s, central banks came to the conclusion that they really did have to control inflation. And that they were able to do it. And so, the period of the early 1980s was a period of disinflation in most of the Western world; the United States, Japan and Western Europe. And inflation continued to decline through the mid-’80s and even into the early 1990s.
And by the late ’80s or early ’90s, central banks started to ask themselves, how can we maintain this good outcome? How can we prevent a recurrence of the high inflations that we saw in the 1960s and ’70s? And the answer was that central banks believed that they should have a specific commitment to keep inflation low. And that’s how the first inflation targets were created. They arose from the ashes of the disinflations of the 1980s.
Beatty: Around the world, most central banks have an inflation target of around 2%. And how did they come to that number, and what’s important or significant about that number?
Neely: When central banks were setting their inflation targets, they were trying to take into account the ideas that while inflation has costs, having absolutely no inflation might also have costs. So, economists generally thought and still think that high and volatile inflation has much higher costs than very low and stable inflation. When central banks were considering what sort of an inflation rate to target, they were really trading off the costs of having inflation with the benefits of having some upward movement in prices which might have benefits in terms of allowing central banks to stabilize the macroeconomy.
So, 2% was, kind of, a happy medium. If you go much lower than 2%, than you really come very close to zero inflation at all. And if you go much higher than 2%, then you started to run into higher costs of inflation. So, 2% was kind of a Goldilocks solution.
Beatty: For many accounts, this inflation targeting era that you described has been viewed as successful. So, would central banks ever consider changing a target, or changing the methodology of a target given that they’ve had success with explicit inflation targeting over the past 30 years or so?
Neely: Many of the central banks that have chosen to target inflation have actually changed their targets because many of those central banks have used inflation targeting as one instrument in their toolkit to bring inflation down from very high levels. So, many central banks have had successive inflation targets where the inflation target gets lower and lower and closer to the 2%.
However, once central banks have achieved a 2% inflation target and fairly stable inflation, I don’t really know of any that have either given up on the target or that have raised the target significantly. In fact, I think it’s probably pretty rare to find changes in an inflation target aside from the reductions in targets that are associated with a central bank bringing down inflation.
I do know that in the recent framework review that the Federal Reserve is in the process of conducting that the Fed has specifically stated that reviewing and changing the inflation target will not be a part of that review.
Beatty: Let’s move on to talking a little bit more in theory about, kind of, contrasting and comparing the advantages of raising an inflation target or lowering an inflation target. What would be the advantages of raising an inflation target for a country?
Neely: Well, there are some economists who think that 2% is too low for an optimal inflation target. And those economists would point out that a higher inflation target would have a couple of related advantages.
First, a higher inflation target would allow a central bank more room to lower nominal interest rates. Because the level of nominal interest rates is inherently connected to the level of inflation because inflation is built into interest rates.
So, if a central bank had a 2% inflation target, and then, say, went up to a 4% inflation target, its, sort of, average nominal interest rate might rise from, say, 3% to 5% as the inflation rate increased. And then the central bank would have greater room to reduce nominal interest rates to the zero lower bound or maybe a bit below zero, depending on the country’s financial system, would have greater room to reduce nominal interest rates to fight recessions.
It would also mean that a higher inflation rate would also have the advantage that some economists see, in that a higher inflation rate might reduce problems with what some economists see as downward sticky wages and prices. And this is a controversial idea, but many economists would argue that people are unwilling or really don’t like to see their nominal prices or their nominal wages decline. And that if they are in a position where they have to accept a nominal wage cut, that this could conceivably lead to unemployment rather than a nominal wage cut.
So, many economists would argue that a little bit of inflation greases the wheels of the economy by permitting, instead of a nominal wage cut, permitting wages to rise, but rise more slowly than the inflation rate. Now, I do want to emphasize that not all economists agree with this idea.
Beatty: You mentioned 4%. And you talked a little bit about, you know, why a little bit of higher inflation targeting could help the economy overall. Is it important to have a fixed target, or is targeting a range a possibility?
Neely: Well, some central banks that have inflation targets do target a range. I, myself, don’t see too much of a difference between targeting a point and targeting a range. People make complex arguments about why a range might be better than a point or a point might be better than a range. But I really don’t see too much difference between a point and a range. When we say we’re going to target a point, we all know that central banks are not going to actually be exactly hitting that point. And we all know that if the actual inflation comes in close to that point, central banks are going to be pretty satisfied and they’re not really going to take action.
Beatty: OK. So, we talked a little bit about the targeting inflation either explicitly, implicitly, a range, point. But what about the communications? So, part of the benefit of having an inflation target is the central bank communicating about it so that consumers understand, have certainty and their expectations then can be built around this inflation target.
If an inflation target were raised or lowered, how would the central bank go about communicating this to the public effectively? And how then would people have confidence in this number, knowing that it had changed?
Neely: Changing an inflation target is a tricky issue because the whole purpose of inflation targets is to introduce certainty to allow people to make economic plans based on a particular average rate of inflation over a period of time. And so, if you’re going to go and change the inflation target, that does create problems because it introduces uncertainty into a tool that was supposed to produce certainty.
On the other hand, nothing that’s created by people is going to be unchangeable. Right? We know that any policy could be changed under the right circumstances and for the right reasons. So, there’s a little bit of a tension between the idea that central banks may be committed to an inflation target. And yet, at the same time, the central bank knows that under the right circumstances, it might be best to change that inflation target.
Beatty: On the flip side, what would be the drawbacks of raising an inflation target? What’s the counter argument here?
Neely: Well, first there’d be the question of uncertainty, right? That a central bank that has committed itself to an inflation target, if it changes that inflation target, it undermines the certainty that it was trying to create with the inflation target in the first place. But leaving that aside, a higher inflation target would be associated with higher inflation, perhaps a little bit more volatile inflation. And inflation has several costs. Inflation makes it harder to plan financially. It makes calculations a little bit more complex. And if inflation is more volatile, that creates more difficulty in planning for things like how much you need to save for retirement. Higher or more volatile inflation will make people more reluctant to sign long-term nominal contracts like fixed-rate mortgages or labor contracts.
Volatile inflation can also have somewhat arbitrary transfers between people. So, for example, if you have a fixed-rate mortgage and you and the bank that gave you the mortgage figured when you signed it that inflation would about 2%, and then inflation rises permanently to an average closer to 4%, well, that’s great for you because you get to pay back the mortgage in devalued dollars. But it’s bad for the bank. So, volatile inflation or changes in inflation can create arbitrary transfers.
Inflation also interacts with the tax code in strange ways that create what economists call economic distortions. So, for example, capital gains taxes are typically not fully indexed for inflation. So, inflation is going to, sort of, artificially raise capital gains taxes and tax gains that aren’t real gains.
Also, a traditional argument against higher inflation is that inflation is a tax on holding cash. So, if you’re holding cash in your drawer or under your mattress and prices rise and rise, then that cash gets less and less valuable. So, it’s actually a tax on cash holdings. And as the rate of inflation rises, then that tax increases and causes people to economize on their cash holdings and do things like, perhaps, have to take more trips to the ATM to get cash, or hold less cash. And those things have real costs.
Beatty: If you’re a saver and you keep large piles of cash as my grandfather did in his freezer, or you keep it in a bank account that pays little to no interest, how would higher inflation impact you?
Neely: If your grandfather has a freezer full of cash, then as inflation raises, the prices of goods and services in the economy, then that freezer full of cash is going to be able to buy fewer and fewer goods. And so, it’s going to decline in value. So, really, that inflation is going to be a tax on your grandfather’s cash.
So, a lot of economists would argue that a primary cost of inflation is the fact that it taxes cash and causes people to not want to hold cash and therefore, sort of, distorts their economic behavior.
But other economists would point out that many of the people who hold cash are people that we would like to tax. For example, most people probably don’t realize it, but most U.S. currency is held outside the country by foreigners. And even much of the currency held inside the country is held by people engaged in illegal activities. So, when we tax cash with inflation, then the tax on cash is really disproportionately hitting people who are not Americans or people who are engaged in criminal activity or both. And those are groups of people that the typical taxpayer, I would think, would say, hey, “I’d like to tax those people more and pay a little bit less taxes myself.”
Beatty: So, we’ve talked a little bit about the advantages, disadvantages of raising an inflation target. But are there economists out there arguing for the opposite, to actually lower an inflation target?
Neely: I think that there are certainly are economists who believe that the ideal rate of inflation would be zero properly measured. For instance, I think that a former president of this bank, Bill Poole, is on record as saying that a zero percent inflation rate properly measured would be his ideal inflation rate. These would be economists who would typically believe that price stickiness, wage stickiness is not a big problem. And that countercyclical monetary policy is not particularly important for pulling the economy out of recessions.
Countercyclical monetary policy just means reducing interest rates when times are bad and raising interest rates when times are good.
Beatty: So, the Fed has missed its inflation target for quite a few years now. Do you see that as a problem for the Fed that inflation hasn’t been at 2%?
Neely: We should put the Fed’s experience and the Fed’s performance in context. So, it is true that since about 2013, the PCE inflation rate has run below the 2% inflation target almost all of that time. But it’s also true that the average inflation rate since that time hasn’t been that far below 2%. I think that it’s been about at 1.35% since 2013. And it’s been at about 1.75% since 2017. So, the Fed hasn’t done too bad of a job hitting its inflation target. Although currently, the PCE inflation rate is a bit below the target. But I don’t think it’s really cause for serious concern unless, essentially, the problem persists indefinitely or gets worse.
Beatty: Is there something else going on in the economy, either in the U.S. or globally that could be causing lower than expected inflation? Or do you think it’s potentially a measurement problem?
Neely: I don’t really think it’s a measurement problem. There are measurement problems with inflation, but I don’t think that these measurement problems have gotten any worse in the last few years or over the last decade or two. In fact, I think probably to some extent, they’ve gotten a bit better. Instead, we do see that the major central banks, the Bank of Japan, the European Central Bank and the Fed have all had some problems to one degree or another in hitting their desired rates of inflation.
The Bank of Japan has had essentially almost no inflation since about 1995. I think a cumulative total of only about 4% inflation in about 25 years. So, that’s essentially zero inflation. And that’s despite the fact that the Bank of Japan has had a 2% inflation target since early 2013 and had been trying to raise inflation prior to that.
So, the Bank of Japan has had a lot of problems raising inflation. And the reasons why they’ve had problems raising inflation are a little bit complex. But it might come down to the fact that they started late and they’ve had some missteps on the way. They’ve gone back and forth in terms of trying to raise inflation and then backing off on policies and trying to raise inflation again, and backing off on those policies. I think that after a while, the Japanese public essentially stopped believing that they would succeed in raising inflation. So, they’ve had a really hard time with raising inflation to their 2% target.
The Euro area has also had some problems, not nearly as bad as the Bank of Japan, but perhaps a bit worse than the Federal Reserve. So, the European Central Bank, that is the ECB, shoots for inflation close to or below 2%. But in practice, its inflation rate has almost always been below 2% and usually well below since 2013. It’s even averaged less than 1%, I think, since 2013. And if you look at their so-called core inflation rate—that is, the inflation rate that excludes food and energy, that’s been even lower.
Beatty: How do central banks balance going about setting and achieving these inflation targets over a medium to long term when they have to deal with shocks or risks that come along and that they, in fact, might have to respond to?
Neely: Certainly, there are short-term shocks to the price level. So, for example, if there, you know, would be disruptions to oil supplies, that’s going to cause a significant rise in oil prices around the world. And that’s going to have some effect on the overall price level. The policy of the Federal Reserve has been to target the current and near-term inflation rates and to essentially ignore past deviations from those inflation rates. So, this is a so-called let bygones-be-bygones policy.
So, under such a policy, if oil prices cause a spike in inflation rates, the Fed would essentially ignore that spike in the future, bring inflation back down to 2%, but not seek to reverse the effect of that spike on the price level, just as the Fed is not currently planning to reverse the effects of the low inflation we’ve seen over the past few years on the price level going forward.
So, essentially, the Fed, and I believe other major central banks basically accept that there are going to be shocks to the price level. And once those shocks have hit, they ignore them and seek to achieve their inflation target in the future.
Beatty: Great. Thank you very much, Chris, for your time and for providing insights into understanding the role of central banks and inflation targeting.
Neely: Well, thank you for having me, Jenn.