Why Central Banks Should Target 4% Inflation

It is October 29, 1929 , also known as Black Tuesday. The Great Depression, one of the largest economic downturns in history, has just begun. Unbeknownst to the everyday man and woman, this will last a backbreaking decade, during which these everyday people will see their dreams slashed in the face of lower wages. That is, if they even find a job in the first place; unemployment will reach almost 25% in America at the height of the depression in 1933. During this time, it’s obvious that we will start looking to policymakers for solutions to this problem, however, even they have been silenced by the lunacy of the gold standard: there are no solutions in the pipeline.

Time for a voyage into the future. 1990, specifically – New Zealand. The Reserve Bank of New Zealand has just introduced a pioneering measure that will shake up monetary policy: the inflation target. They say they target a rate of price increase of 0 to 2%. Fast forward 22 years, and on the 25 January 2012, Ben Bernanke, the chairman of the most famous central bank in the world, the Federal Reserve, has introduced a 2% inflation target. Nowadays, the magic “2” is the norm, with central banks from the Bank of England to the Bank of Japan adopting the target. The problem? Well, there’s more than one, but the most arresting drawback is that we’re veering into very dangerous territory should we be even slightly amiss in meeting these targets.

Say we undershoot from our inflation target. That can happen, right? People make mistakes – even big, bad central bankers. If prices, therefore, appreciate by only 1% a year, that’s not too bad. But say we adjust the degree of error even more, and then we’re veering dangerously into deflationary territory – a nightmarish decrease in prices. In both my opinion and the opinion of many others, deflation is far worse than even high levels of inflation. This is because a deflationary slump in an economy causes people to think twice about purchasing goods and services, reducing demand for these goods and services, decreasing their prices to levels lower than they already are.

Intuitively, this causes job layoffs as the reduction in demand causes a corresponding reduction in corporate revenue, and so the freshly unemployed aren’t very likely to buy non-essentials like a bottle of Coke or a packet of gum, let alone a new house. The ensuing vicious downward price spiral amidst a plethora of redundancies has historically been extremely difficult to get out of; deflation can batter an economy like nothing else. Where do we look for an example of this? Back to the past, that’s right – the Great Depression, where prices plummeted and redundancies soared due to a collapsing banking sector.

Moreover, recessions happen. We can’t prevent all of them, and it’s a fact of life that the average person is overwhelmingly likely to experience at least one or two in their lifetimes, if not many more. It’s how a central bank deals with the recession that defines how strong and robust their monetary policy is, and when you can only decrease interest rates by a small amount, then you’ve got a problem. Take the Bank of England. Interest rates currently sit at staggeringly low levels: 0.5%, to be precise.

Let’s assume they meet their inflation target of 2%, and so the nominal interest rate (the interest rate when we don’t take into account inflation) will be 2.5%. Now, let’s hypothesise that they increase their inflation target to 4% and meet it (I know, I’m optimistic about their abilities). Now we have a wiggle room of a whole 4.5% should we face a recession, so we have a greater chance of stimulating the economy and getting it back on track.

Even taking into account that central banks may not meet these targets, it’s logical to believe that they’ll at least achieve a higher inflation rate than before, and so regardless of the scenario, the overwhelming likelihood is that we’ll have more chance of beating back a recession than before.

Finally, we need to lend the companies that are the backbone of our economy a hand in being able to dish out nominal wage increases. Again, let’s take a scenario whereby we have higher inflation, say 3% (due to central banks undershooting the 4% inflation target) and the nominal wages of not very productive employees operating in, for example, McDonalds rise by 2%. In reality, they’ve still got 1% less purchasing power than they did before, however McDonalds’ 2% rise in wages keeps them happy and satiated; they won’t go on strike or resign or do all the things that corporations fear so much.

Say we had a much lower inflation rate, perhaps 1%. Now, McDonalds is in hot water because they can only increase wages by a small, small amount, risking the ire of its employees. If the inflation rate went even lower, then we have even more of a problem; McDonalds cannot hand out relatively large nominal wage increases, as if they were to do so, their costs would increase, therefore enabling a reduction in profits. So now we have annoyed corporations, annoyed employees and perhaps an economy on the verge of recession, with very little room to alter interest rates when we enter one. All because of those dastardly low inflation rates.

Since 1990, the inflation target has become one of the key symbols of monetary policy and central banking. We need to increase it; I think it’s time to change this symbol for the better.

Do you?