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The Outlook: Central Bankers Rethink Strict 2% Inflation Target -- WSJ

3 Apr 2017 6:32 am

Central banks begin looking at alternatives to a rigid 2% guideline in place for decades
By David Harrison 

Inflation has finally returned to the Federal Reserve's 2% goal after undershooting it for nearly five years. Now, just as the central bank has inflation where it wants it, economists and central bankers are starting to think such a rigid goal is a mistake.

After that long period of exceptionally low inflation and interest rates, central banks are talking about alternatives to the target, many of which involve the option of letting inflation rise above 2%, either permanently or for a time.

"This is one of those ideas that has moved from a crazy idea that no one would discuss to an idea that is being seriously discussed by important policy makers," said Emi Nakamura, an economist at Columbia University.

Central bankers, spooked by inflation spikes during the 1970s and early 1980s, had come to view targets as a core tenet of sound monetary policy. In the 1990s and 2000s, many picked a 2% target, seeing it as not so high that it would disrupt business decisions and wage negotiations, and not so low that it would make interest rates unmanageable.

The financial crisis and its aftermath shifted the consensus. Instead of high inflation, today's central banks are confronted with aging populations, lower long-term growth and higher saving rates. Those all hold down the real natural interest rate -- the equilibrium interest rate, adjusted for inflation, that keeps borrowing, lending and the broader economy in balance.

A very low natural rate is a problem for central bankers, who manipulate short-term interest rates to manage their economies. When the economy heats up, they push rates higher to slow it down. When the economy slows down, they cut rates to speed it up.

When the natural rate is very low, central banks risk running rates into zero when they're trying to cut, effectively running out of room to stimulate the economy in a downturn.

New research by Fed economists Michael Kiley and John Roberts suggests Fed officials may now confront near-zero interest rates 40% of the time or more because of the low natural rate.

Olivier Blanchard, an economist at Peterson Institute for International Economics, kicked off the debate over higher inflation in 2010 when he suggested a 4% target while serving as the International Monetary Fund's chief economist. The idea was that a steady rate of higher inflation would mean that nominal interest rates could be higher too, leaving central banks more room to cut in a downturn to boost output.

Fed officials rejected the idea of changing the inflation target as overly disruptive. But the debate is getting new life and economists are increasingly talking about other approaches that would have the same effect of letting inflation drift up without resorting to a higher target.

Messrs. Kiley and Roberts, in their paper, don't endorse a higher inflation target. But they do suggest U.S. policy makers could let inflation exceed 2% for a time after recessions to give the economy more room to grow and more time to recover lost ground during a downturn.

Although the Fed remains committed to a 2% goal, it shows signs of tilting in this direction. Its March 15 policy statement stressed the inflation aim is "symmetric," meaning the central bank would tolerate slightly higher or lower inflation temporarily.

Officials have previously described their target as "symmetric," but including the word in the closely watched meeting statement caught observers by surprise.

"This seemed like a good time to remind Americans that what our objective is is 2% inflation," Chairwoman Janet Yellen explained in the postmeeting news conference. "There will be some times when [inflation is] above 2% as well," she said.

Other countries are going in this direction. The Bank of Japan committed last year to overshoot its 2% target. Sweden's Riksbank is considering reintroducing a band around its 2% target, allowing officials to undershoot or overshoot when needed.

Inside the Fed, San Francisco Fed President John Williams has become a leading proponent of a rethink.

Economists and policy makers "need to put on their thinking caps, analyze the costs and benefits of the various alternatives and think seriously," he said last month.

Mr. Williams has suggested adopting the Bank of Canada's practice of formally re-evaluating its inflation target every five years. Although the reviews have consistently kept the target at 2%, Bank of Canada Gov. Stephen Poloz said the latest re-evaluation, which concluded last year, involved taking "a good look" at raising the target.

Tiff Macklem, dean of the Rotman School of Management at the University of Toronto and a former BOC official, said the reviews force policy makers to think hard about their assumptions.

"Throughout history we've seen different monetary policy regimes come and go so in that vein it is important to keep reassessing the regime you have in place," he said. "It's always important to be humble about monetary policy."

Write to David Harrison at david.harrison@wsj.com

(END) Dow Jones Newswires

April 03, 2017 02:32 ET (06:32 GMT)

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