The inflation head-scratcher

An IMF researcher argues higher inflation targets are useful in a financial crisis.

The economic meltdown and sluggish recovery have led many economists and policy-makers to do some soul-searching lately. Just about every economic concept and theory seems to be up for debate, even long-standing beliefs. Take inflation, for example. Central bankers view inflation as a beast to tame into submission. But some economists are wondering if a higher rate of inflation is really so bad.

The idea was most recently put forward in a paper released by the International Monetary Fund. Olivier Blanchard, director of the research department at the IMF, authored the paper and questioned many of the tenets of macroeconomic policy. His most controversial suggestion was that higher inflation is beneficial heading into an economic crisis. Central banks in most industrialized countries, including the Bank of Canada, attempt to keep inflation below 2% a year, allowing for price stability in the economy. But this may have left them somewhat ill-equipped to deal with the calamity in 2008. A lower inflation target means lower nominal interest rates, and when the crisis hit, central banks had little room to cut rates before effectively hitting zero. The overnight rate in Canada, for example, fell from 3% in September 2008 to 0.25% in just a few months.

Dropping to zero so quickly meant just about every nation had to rely on fiscal measures to stimulate the economy, which accounts for the unwieldy government deficits today, according to Blanchard. “It is clear that the zero nominal interest rate bound has proven costly,” he wrote. If central banks had targeted higher average inflation, on the other hand, interest rates would also have been higher, allowing central banks more space to slash rates to keep the economy functioning.

Blanchard asked in the paper if inflation targets should be raised from 2% to 4% in the future toprepare for potential economic shocks, but he adopted a much stronger tone in an interview with The Wall Street Journal. “If I were to choose [an] inflation target today, I’d strongly argue for 4%,” he told the paper in February. “Between 2% and 4%, there isn’t much cost from inflation.”

Blanchard’s argument runs contrary to decades of monetary policy, but any idea to help prepare for future collapses is at least worth discussing, says Douglas Porter, deputy chief economist at BMO Capital Markets. “We’ve been through a couple of cycles now where it seemed like central banks could not cut rates enough to generate a turnaround in the economy, because the starting point was relatively low,” he says. “I just wonder if the cure here is worse than the disease.”

There could be plenty of costs from targeting 4% inflation, particularly around incomes. Not every pension plan is indexed to inflation, for example. Real income would drop by the rate of inflation every year once the recipient of the plan retires and starts to withdraw from it. A 4% depreciation compounded over a few years could be devastating. Inflation causes problems for wages, as well. Workers expect their earnings to keep pace with inflation, and a more substantial rate will likely lead to demands for ever higher wages. The situation can quickly spiral out of control, resulting in higher interest rates and runaway inflation. “My worry is that it’s a slippery slope,” says Craig Wright, chief economist at RBC Financial Group. “The risk is, if 4% is better than two, then maybe six is better than four. Where do you stop?”

The question Blanchard essentially put forward is whether having more insulation against unprecedented economic events is worth the risks associated with higher inflation. But recessions as severe as the one the worldjust experienced are rare. “You want to set policy based on the most likely outcomes, rather than the least likely outcomes,” Wright argues. Central banks also have many more options to juice the economy beyond simply lowering interest rates, such as buying back government debt, as they demonstrated when responding to the crisis. “They were hardly handcuffed by the zero bound in interest rates,” says Don Drummond, chief economist and senior vice-president at TD Bank Financial Group.

But having more room to cut rates isn’t the only reason leading some economists to flirt with higher inflation. In the heart of the meltdown in late 2008, Harvard University economics and public policy professor Kenneth Rogoff wrote in the Guardian that a “sudden burst of moderate inflation would be extremely helpful in unwinding today’s epic debt morass.” Inflating away debt looks especially tantalizing to the U.S. today, where the debt-to-GDP ratio is shooting above 75%. Inflation helped the country before. Between 1946 and 1955, inflation averaged 4.2% and reduced America’s postwar debt-to-GDP ratio by 40%, according to Joshua Aizenman and Nancy Marion, economic professors at the University of California and Dartmouth College. The two argued in a paper in December that an inflation rate of 6% for four years today would reduce America’s debt-to-GDP ratio by 20%.

So far, the U.S. has shown no willingness to move in this direction. But Glen Hodgson, senior vice-president and chief economist at the Conference Board of Canada, worries the country just might choose to. “Politics always crowd out policy,” he says. Allowing inflation to drift upward to reduce government debt is more favourable politically than raising taxes or slashing public spending, and that has implications for the Canadian economy. U.S. inflation would cause the dollar to decline and send the loonie even higher, pummelling the domestic manufacturing sector.

The downsides to higher infltion are indeed significant, and all of the risks need to be examined when toying with the idea, something even its proponents acknowledge. “Once the inflation genie is let out of the bottle,” Rogoff wrote in 2008, “it could take several years to put back in.”