Wednesday, October 20, 2010

Price Level Targets

A key issue for inflation, is which target should we adopt. The most common target for Central Banks around the world is 2%. E.g. the UK pursues a target of 2% +/- 1. The ECB pursues a target of less than 2%

However, on some occasions, these inflation targets can appear misleading. For example, just before the Great Recession, inflation jumped to 5% because of cost push factors. This led to Central Banks resisting interest rate cuts even as signs of the recession materialised.

As we emerge from the recession, inflation in the UK has been higher than you might expect from this stage of the economic cycle. UK inflation has been above the government's target for a few months in a row. This is seen by some as a justification to tighten fiscal policy. However, with rising unemployment and much spare capacity, maybe this inflation target is again misleading.

One solution is simply to raise the inflation target to 3 or 4% as some have suggested (see: Optimal Inflation Target). However, other economists are worried this will worsen inflation expectations and make it more difficult to keep inflation under control.

Price Level Target

Another solution is a target for prices rather than inflation. For example, we could have a target for prices to rise by 2% a year. If prices only rose by 1% in one year, this would mean the target for price rises would be 3% to catch up with what we missed. In other words if we enter a recession, we should have more leeway when the recovery starts.

In practical terms, it means we shouldn't worry about inflation of 3%, because a year ago, inflation was below target. Because there is spare capacity there is less chance of inflation taking hold.

The advantage of this Price Level Target is that, in a liquidity trap, it may encourage consumers to spend, because they expect a rise in inflation. It may avoid some of the problems that arose in Japan during the period of deflation.

The problem with price targets is that it could create more volatility. For example, if we had two years of deflation of -2%, the next year's target could be an inflation rate of 6%. This has the danger of going from one extreme to the other.

Perhaps more likely is the fact that inflation could be well above the annual target of 2%. This could leave the Central Bank with trying to reduce prices. To be targetting deflation, wouldn't make any sense given the problems this would cause.

Also, another criticism is that the price level target is likely to cause confusion, as people fail to understand it. Also, there is no guarantee a price level target will influence expectations in the way Central Banks hope. Expectations are more likely to be swayed by actual conditions and monetary policy.

Flexibility in Inflation Targets

A simple inflation target of 2% has certainly many merits. Since inflation targets have been introduced, in the mid 90s, we have experienced lower rates of inflation than previously. But, inflation targets are not the be all and end all of economic policy.
  • You can still have a credit boom and bust with low inflation (e.g. 2004-2007)
  • Also, in a liquidity trap, with mass unemployment and stagnant growth, attaining an inflation target is scant comfort when there are more important objectives.
Central Bankers definitely need to maintain low inflation expectations. But, they also need to be able to aware of temporary, short term factors which are misleading to the state of economy. This is something, the Bank of England is trying hard to achieve. I'd rather have this more flexible stance than the hard core 'inflation is always the greatest priority' that the German dominated ECB adopts. The Irish, Greek and Spanish economies will get no joy from knowing the ECB is maintaining low inflation expectations in the Eurozone whilst their economies experience painful economic contractions.

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