Germany Central Bank Statement

Author: | Published: 19 Oct 2018
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One of the outcomes of the financial crisis has been an in-depth debate on the lessons for monetary policy, including the question of whether the inflation target should be higher in order to widen the safety margin between the nominal interest rate and the effective lower bound, thus broadening monetary policymakers' room for manoeuvre.

Monetary policy inflation targets are the result of a complex decision involving a trade-off between costs and benefits. Raising the inflation target may appear beneficial at first glance. A credible higher inflation target reduces the likelihood that the effective lower bound will bind, because the average nominal interest rate – the sum of the real interest rate and expected inflation – increases with the higher target.

Conversely, costs related to a higher inflation target arise in every period from nominal rigidities because they distort relative prices and, hence, impair the efficient allocation of resources within the economy.

Other adverse implications of a higher inflation target, however, are often underappreciated. In particular, it can affect the price-setting behaviour of firms in the economy. The higher the inflation target, the more likely firms are to become "forward-looking". In other words, with higher trend inflation, a price-resetting firm will set its prices higher, as it anticipates that a higher inflation rate will erode its relative prices faster in the future. As a consequence, this leads to a fall in the relative importance of current marginal costs, and therefore of the output gap, in determining the inflation rate today. Thus, technically speaking, if the central bank raises the inflation target, the (short-run) New Keynesian Phillips curve flattens, and the inflation rate becomes less sensitive to variations in current output.

Correspondingly, for a given change in the inflation rate, the central bank has to change its policy rate to a greater extent. A higher inflation target therefore diminishes monetary policy effectiveness due to a flatter Phillips curve. Ultimately, the central bank loses part of the policy space it has seemingly gained, but the welfare costs of inflation caused by further distortions in relative prices remain.

What likewise deserves more attention in the current debate about a higher inflation target is the associated risk of inflation expectations becoming unanchored. Firmly anchored inflation expectations are key to the ability of monetary policy to achieve and maintain price stability. Moving to a higher inflation target could jeopardise the anchoring of inflation expectations and impair the credibility of the central bank.

Finally, other considerations, such as inflation aversion and the availability of unconventional monetary policy instruments at the zero lower bound, provide further arguments against higher inflation targets. Evidently, the underlying implications of raising the inflation target are more complex than they first appear. Even though monetary policy research on this issue is still in its infancy, a strong case can be made at present for not abandoning the monetary policy consensus within the developed economies, ie for keeping the target inflation rate at about 2% per year over the medium term.