WASHINGTON — The cardinal rule of central banking, in the United States and in most other advanced industrial nations, is that annual inflation should run around 2 percent.þþBut as the Federal Reserve prepares to start raising its benchmark interest rate later this year to keep future inflation from exceeding that pace, it is facing persistent questions about the wisdom of the rule and the possible benefits of significantly increasing its target.þþHigher inflation could disrupt economic activity, but it also would enhance the Fed’s power to stimulate the economy during recessions. And some experts say the struggles of the Fed and other central banks to provide enough stimulus since the Great Recession suggest they could use more room for maneuvering.þþ“Most developed countries’ central banks have experienced difficulty in providing sufficient monetary stimulus to spur a robust recovery in their economies,” Eric Rosengren, president of the Federal Reserve Bank of Boston, said in a recent speech in London. “This may imply that inflation targets have been set too low.”þþThe Fed’s policy-making committee meets in Washington on Tuesday and Wednesday, and officials are expected to discuss how much longer the central bank should hold its benchmark rate near zero, as it has done since December 2008. Officials had planned to start raising rates between June and September, but growth has fallen short of the Fed’s expectations this year, which could delay the liftoff.þþInflation has mostly remained well below the 2 percent target since the global economic downturn. The Fed’s preferred measure, published by the Bureau of Economic Analysis, rose just 1.4 percent during the 12 months ending in February.þþBut Fed officials want to start raising rates in anticipation of stronger growth and faster inflation. William C. Dudley, the president of the Federal Reserve Bank of New York, said last week that “hopefully” the Fed would make its first move this year.þþThere is little prospect that any major central bank will raise its inflation target in the foreseeable future. Two percent is a global standard and the official line – in Japanese, German and English — is that it was carefully chosen, and that the stability of the target is a virtue in its own right.þþþAdvertisementþþþþThere is also considerable political opposition to higher inflation. Some conservative economists and politicians argue that central banks should aim to keep inflation well below 2 percent.þþBut even as the Fed moves ahead, the broaching of the inflation targeting issue by Mr. Rosengren and other prominent officials – including Olivier Blanchard, chief economist of the International Monetary Fund – suggests an emerging willingness among policy makers to revisit an issue that for more than a generation has been treated as all but written in stone.þþThe case for raising the 2 percent target rests on the counterintuitive idea that moderate inflation is a good thing, helping to grease the wheels of commerce and prevent an outright fall in prices. This is widely accepted by economists. It is the reason that central banks aim for a modest inflation rate, rather than keeping prices at the same level from year to year. The question is, How much?þþContinue reading the main story þþCentral banks influence economic growth by raising and lowering borrowing costs. Higher costs crimp risk-taking; lower costs stimulate expansion. Those costs, expressed as interest rates, combine the price of money with an additional increment to compensate for inflation. Higher inflation means rates will run higher in normal times, allowing the Fed to make larger cuts during periods of duress.þþIn recent decades, as inflation generally declined, the Fed has had less room to make cuts. The Fed, for example, cut rates by 6.75 percentage points beginning in 1989, and by 5.5 points beginning in 2001. On the eve of the crisis in 2007, the Fed’s benchmark rate stood at 5.25 percent. The Fed rapidly reduced that rate almost to zero – but that did not provide enough stimulus on its own to revive the economy.þþLaurence Ball, an economist at Johns Hopkins University, proposed in a 2013 paper that central banks should adopt 4 percent inflation targets. The benefits of avoiding a return to the so-called zero lower bound, he said, outweighed the potential economic disruption.þþ“A 2 percent inflation target is too low,” he wrote. “It is not clear what target is ideal, but 4 percent is a reasonable guess, in part because the United States has lived comfortably with that inflation rate in the past.”þþThe case for a higher target has been strengthened in recent years by a global decline in borrowing costs, which might be offset by higher inflation.þþIn April 2012, Fed officials predicted the benchmark rate would return to about 4.2 percent after the economy had recovered. In the Fed’s most recent predictions, in March, the average estimate was that the rate would reach 3.7 percent.þþAnd some economists regard even those estimates as optimistic. Lawrence H. Summers, the former Treasury secretary, argues that the developed world may have entered a period of “secular stagnation” in which borrowing costs are unlikely to rise significantly above current levels because of chronic lack of demand.þþJohn Williams, president of the Federal Reserve Bank of San Francisco, said in an interview earlier this month that if Mr. Summers was correct, it might become necessary for the Fed to consider raising its 2 percent inflation target.þþ“If you really thought that’s the world we’re in because of the demographics or productivity growth — if that’s really what our future holds — I think that’s just a reality that you need to think about monetary policy and its ability to achieve goals,” Mr. Williams said. “Is the 2 percent inflation goal sufficiently high in that kind of world? These are the kinds of issues that you have to take seriously.”þþBut Mr. Williams, like most central bankers, is not yet ready to do so.þþHe said the Fed had demonstrated in recent years that it retained considerable power to stimulate growth even after cutting rates nearly to zero through bond purchases and by announcing that it intended to keep rates near zero for an extended period.þþDavid Lipton, the senior American official at the I.M.F., said recently that the crucial lesson was that central banks needed to take such measures more quickly. “It isn’t necessarily that you ought to be at 3 or 4, it’s that when you’re at 2 you’re just much more careful about preventing it from falling,” he said.þþContinue reading the main story Continue reading the main story þþContinue reading the main story þþIt is also possible that rates will increase more than the Fed expects, easing the pressure. Ben S. Bernanke, the former Fed chairman, has argued in response to Mr. Summers that rates are being suppressed by a “savings glut” in some countries, notably Germany, that is likely to dissipate as growth improves.þþJames Hamilton, a professor of economics at the University of California, San Diego, co-wrote a recent paper that reached a similar conclusion.þþ“Those who see the current situation as a long-term condition for the United States are simply overweighting the most recent data from an economic recovery that is still far from complete,” Mr. Hamilton wrote in a blog post.þþFed officials also see benefits in maintaining the 2 percent target, which was formalized in 2012 but had long been acknowledged informally. People have come to view 2 percent inflation as a reliable constant. When oil prices rose in the middle of the last decade, measures of inflation expectations showed that American consumers remained confident the effects would subside. In recent years, as inflation has consistently fallen short of the Fed’s goals, those same measures show that confidence in an eventual rebound has not wavered.þþ“I don’t see anything magical about targeting 2 percent inflation,” Mr. Bernanke said at a panel sponsored by the I.M.F. But he added that the costs and disruptions of moving to a higher target could outweigh the benefits.þþA higher inflation target also would require political support. Congressional Republicans already are upset that the Fed is trying to raise inflation back toward 2 percent. They would loudly object to any effort to enshrine a higher target.þþSome Fed officials also see considerable costs in tolerating more inflation. Stanley Fischer, the Fed’s vice chairman, said at a separate I.M.F. event this month that it was important to keep inflation low enough so that people did not need to pay it any attention. At 2 percent annual inflation, it takes about 36 years for a dollar to lose half of its value; at 4 percent inflation it takes about 18 years.þþ“When you start getting up to 4 percent inflation you begin to see signs of indexation coming back and a whole host of the inefficiencies and distortions,” Mr. Fischer said. A 4 percent target, he concluded, would be “a mistake.”þ
Source: NY Times
