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
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.