Janet Yellen, the Federal Reserve chair, has given new impetus to a simmering debate in central banking as she declared the question of whether inflation targets should be raised to be one of the most critical facing monetary policymakers anywhere in the world.
Her concern is that in a world which requires low interest rates even when economies are healthily running at full employment, there is not much scope to cut rates in times of difficulty and the likelihood is that rates get stuck at the lower bound of zero for long periods.
This threatens to trap economies into a low-growth, low-inflation paradigm for long periods, damaging the prosperity and stability of leading economies.
Ms Yellen stressed in her press conference last week that there were both costs and benefits to a higher inflation target, but she added that the Fed would be reconsidering the topic at a future time. “We very much look forward to seeing research by economists that will help inform our future decisions on this.”
The Fed chair is not the first policymaker to broach the subject.
The idea of higher inflation targets was floated by former International Monetary Fund chief economist Olivier Blanchard in 2010, but it gained little traction and was dismissed later that year by Ms Yellen’s predecessor Ben Bernanke.
In 2014, Ben Broadbent, the Bank of England’s deputy governor for monetary policy said there was “impeccable logic” behind the idea of higher inflation targets giving central bankers more room to loosen policy and stimulate the economy when the neutral rate was low.
The issue was lifted up the agenda earlier this month when a group of 22 economists including Narayana Kocherlakota, the former Minneapolis Fed president, and Jason Furman, the former chair of Barack Obama’s Council of Economic Advisers, wrote to Ms Yellen saying the Fed should appoint a commission to consider raising its 2 per cent objective.
Joseph Gagnon, a fellow at the Peterson Institute for International Economics and another signatory to the letter, said the US appeared to be “ahead of the pack” on discussions about the inflation target, but that there were a number of other economies including the eurozone, Japan and the UK that should be asking similar questions.
Last year the Bank of Canada examined the issue before leaving the goal unchanged. The intervention of Ms Yellen, who as the Fed chair is the most influential central banker on the planet, is the most significant yet.
Mr Kocherlakota, who is now at the University of Rochester, said that if the Fed were to review the target it would hopefully spur other central banks to do the same. He told the FT: “The important thing is to have a re-evaluation within the Fed and probably other central banks in light of new evidence and new theory.”
If the Fed were to hold a review it would not necessarily lead to a change, as the 2013 and 2016 reviews in the UK and Canada demonstrated. Policymakers believe the benefits of a new, higher inflation target should be able to clear a high hurdle and exceed many potential costs and risks.
Japan’s change in its inflation target, where the Bank of Japan now seeks to exceed the 2 per cent objective, is undermined by the central bank’s inability to get core inflation up to the target itself. The European Central Bank feels hamstrung by different attitudes to inflation, particularly a cultural dislike of any price rises in Germany.
There is also a concern that if wages do not follow the inflation target higher, the result would simply be lower living standards and a further shift in resources from labour income to capital. Japan has suffered from the stubborn difficulty in achieving real wage growth to maintain a consistently positive level of inflation.
Tim Duy of the University of Oregon, another signatory of the letter, which was arranged by the Fed Up campaign group, said the Fed has been hesitant about changing its inflation target because of worries about unhinging inflation expectations that have been anchored by the 2 per cent target.
But he said a rethink was sensible nonetheless. “If we have a two- or three-year window before the next recession, we will need to move on this inflation targeting in the near future to be prepared,” he said.
Given the amount of churn looming on the Fed’s board of governors in the coming year it seems unlikely that the US central bank would consider overhauling its framework soon. Ms Yellen herself may well not win a second term when her current period at the helm expires early next year.
But objections to alternatives such as quantitative easing and negative interest rates are running high, so Mr Yellen’s willingness to fuel the debate has sparked huge interest in monetary policy circles.