Deflation

Inflation in this world is relatively predictable. What should the target be? If, as one might believe from all the discussion in the press and elsewhere, inflation is a pernicious problem, then perhaps the inflation target should be zero. Yet most central banks following this policy adopt targets with positive inflation rates, based on the belief that a little bit of inflation may be useful in the economy. One argument often heard is that deflation (negative inflation) is problematic. From a historical perspective, a prolonged period of deflation in the Unites States occurred during the Great Depression and coincided with a negative output growth. More recently, Japan experienced both slow real gross domestic product (real GDP) growth and some periods of deflation during the 1990s. Many policymakers have apparently concluded that deflation is to be avoided because it could underlie a depression. An alternative possibility is that deflation is correlated with periods of low economic activity, but it is unclear whether it is the cause or the consequence of a sluggish economy. Whatever the connection between deflation and depression, the prevailing wisdom of the Fed (and other central banks) is to avoid deflation. Given that the central banks cannot always hit their targets precisely, aiming for zero inflation makes deflation more likely than when central banks adopt a target with positive inflation. In addition, a little inflation may make it easier for relative prices and wages to adjust in an economy. If the demand for beef decreases and the demand for pork increases, then the price of beef should decrease, and the price of pork should increase. Such adjustment is straightforward. Similar logic says that if the demand for accountants decreases and the demand for systems analysts increases, then the wages of accountants should decrease, and the wages of systems analysts should increase. This may be more problematic. People typically respond very negatively if there is an attempt to cut their wages. It may be easier for employers to let inflation do the job of reducing the real wage instead. (This is an argument that makes some economists uncomfortable since it implies irrationality on the part of workers. Still, the psychological resistance to nominal wage cuts appears to be strong.) A second issue is whether the inflation target should be allowed to vary. Instead of announcing a 3 percent target for all times, the monetary authority might decide that the target rate should depend on the state of the economy. For example, they could have a higher target rate in recession and a lower target rate in booms. This way monetary policy could still be used to help keep the economy at potential output. Finally, there is the question of “punishment” for missing a target. If the purpose of inflation targeting is to support a particular (moderate) inflation rate, then a central banker missing the target ought to be fined or even terminated, just like a manager of a store who persistently misses sales targets. Presumably, if a central bank has goals to achieve, it should also have incentives to meet those goals. Central bankers are often called to testify in front of bodies, such as the US Congress, who monitor the progress of the economy relative to particular targets. Australia is an example of a country that follows an inflation target rule. According to the charter of the Reserve Bank of Australia (http://www.rba.gov.au/monetary- policy/about.html), the goal of Australian monetary policy is to maintain inflation between 2 and 3 percent annually, on average. The central bank does also recognize of the role of monetary policy for stabilization purposes.