Since the financial crisis, economists have been debating its possible lessons for monetary policy, including the question of whether central banks should raise the inflation target to enlarge the safety margin to the lower bound, thus broadening their scope for action in times of crisis. The Bundesbank, in its current Monthly Report, counters this proposal by noting that the debate largely fails to take into account the wider implications of a higher inflation target. Ultimately, the Bank’s experts claim, "the central bank has to mount a more aggressive interest rate policy response to economic developments, which means losing part of the room for manoeuvre that has just been gained, while the costs of inflation caused by distortions in relative prices continue to exist".

The primary objective of many central banks is to achieve price stability – this lays the groundwork for maximising welfare in the economy as a whole. At present, the majority of central banks in advanced economies aim to achieve an inflation rate of around 2% and gear their monetary policy to that objective. If inflation is too low, they cut interest rates to boost economic activity. If inflation is too high, central banks raise interest rates accordingly. If, however, monetary policy rates are already very low ‒ as they are now on account of the past financial crisis ‒ central banks can no longer fall back on the conventional monetary policy instrument of cutting interest rates.

Only ostensibly more scope for action

At first sight, raising the inflation target would therefore seem to an obvious solution, it is stated in the Monthly Report. That would push up the average nominal interest rate – the sum of the real interest rate level and the (expected) inflation rate –and there would be greater clearance from the lower bound. In the event of a further crisis, monetary policymakers could then use interest rate cuts to intervene for longer with a greater stabilising impact on economic activity.

"Lost as quickly as it is gained"

Yet, as the Bank’s experts argue, this would only ostensibly give central banks’ monetary policymakers the additional room for manoeuvre they were hoping for. This is because its repercussions for enterprises’ price-setting behaviour would instantly lead to their scope of action being restricted again, meaning that it would be "lost as quickly as it is gained", they write. Enterprises’ actions are fundamentally forward-looking and their present price-setting takes account of the current demand for their goods as well as the expected inflation rate. At the aggregate level, a higher target inflation rate leads to a flattening of the Phillips curve. This makes it more difficult for monetary policymakers to stabilise macroeconomic developments and thus achieve price stability. In the event of an economic slump, an interest rate cut, given a higher target inflation rate, has a smaller impact on aggregate demand than it would if the inflation rate were lower, it is stated in the Monthly Report. Larger changes in the monetary policy interest rate would be required.

Inflation expectations no longer anchored

The Bundesbank’s experts also take a critical view of how the debate about a higher inflation target mostly fails to adequately factor in the risk of inflation expectations becoming unanchored. Inflation expectations play a major role in the actual path of inflation, however. If expectations are not firmly anchored – consistent with the central bank’s inflation target – it is harder to stabilise the inflation rate, they note. In extreme cases, the central bank might fail to achieve its inflation target in both the medium and long term, the economists write. In reality, economic agents form their expectations on the basis of incomplete information. Under the assumption of adaptive learning, rather than of rational expectations, the economists point out that a new, higher inflation target does not initially feed into the formation of expectations, but instead has to be learnt over time from observed inflation rates. This does not necessarily occur, though, because interest rate policy would become ineffective as a conventional instrument of central banks, according to the Monthly Report.

Unconventional measures

Aside from distorted prices and the risk of inflation expectations becoming unanchored, the economists point to other factors that make the benefit of raising the inflation target appear questionable. In the Monthly Report, they note that unconventional monetary policy measures such as the purchase of government and corporate bonds by central banks has shown that there is still scope for action even at the lower bound. Fraught with long-term risks and hotly debated though these measures are, they do put the significance of the lower bound into perspective when viewed in isolation. The economists also highlight the general public’s aversion to higher inflation rates. If this aversion were disregarded in the trade-off, the costs of higher inflation would be understated.

Threat to credibility

Monetary policy inflation targets are the outcome of a complex trade-off process, the Bundesbank’s economists write. They are key elements of monetary policy strategy, they remark, which “are ultimately crucial to the credibility of monetary policy actions”. The economists therefore advise caution when it comes to raising the inflation target.