Inflation Targets Essay

1458 words - 6 pages

A radical central banking policy adopted by New Zealand initially in 1989 that revolves around meeting preset, publicly displayed targets for the annual rate of inflation, is more commonly known as inflation targeting. This policy was adopted later on most notably by countries like Chile, Canada, Israel, Sweden, Finland (Pre- Eurozone), Spain (Pre-Eurozone), Australia, Brazil, Mexico, England and South Africa. The benchmark used for inflation targeting is typically a price index of a basket of consumer goods, such as the Consumer Price Index (CPI) in the United States. Along with inflation target rates and calendar dates to be used as performance measures, an inflation ...view middle of the document...

Now, let’s examine the benefits and drawbacks of the upper (4%) and the lower (2%) bounds here to come up with an ideal inflation target the Fed can follow considering the current state of the US economy.
An article in The Economist argues that a rate of inflation that is too low runs the risk of trapping monetary policy against the zero bound. Figure 2 illustrates the position adopted in the article. If the monetary policy is trapped against the zero bound the Federal Reserve will need to find new ways of economic stimulus in order to revive a receding economy. It is for this reason that some economist today advocates an inflation rate of 4%.
Advocates for a higher inflation rate than 2% argue that once the Federal Reserve commits to a higher rate of inflation, expected future prices will go up and as a consequence current levels of demand would go up giving a boost to current economic activity. For example, if the interest rates fall to zero and there is 4% inflation in the economy then people will not hoard money in their savings account as the real interest rates will be negative 4%. This will force them to invest money in the market to get higher returns to keep up with the inflation. This point can be illustrated using the simple demand-supply model shown in the figure 3 on the right. But raising inflation targets is not the only way to stimulate demand. The monetary policy of Quantitative Easing (QE) can also help shift the demand curve to the right, as shown in figure 3. The idea behind QE is to discourage banks from borrowing money at cheap Fed Funds rate and use them to buy risk-free treasury bonds and thus make money on that spread. Under QE the Fed buys treasury bonds to reduce the yield on these bonds. This decreases the spread between the Fed Funds rate and the Treasury yield and forces the banks to take more risks and lend the money in the open market to investors.
One experiment to check if QE has been successful would be to check the Investment (I) and Personal Consumption (C) levels in the overall GDP composition. As figure 4 indicates, both of these parameters have been steadily increasing since 2009. Investments have increased by 50 % and Personal consumption by 10% since 2009. This indicates that Fed’s current monetary stimulus has been able to stimulate the economy. Under this context it is not required to provide additional stimulus by raising inflation levels. This is because there are a lot of issues associated with higher inflation. The general public can have debt monetization perception about the Fed. This means that the Fed is just printing money to pay out its debt. This might be a serious problem especially in the current situation when US debt has increased to record levels. This perception might actually lead the general public to become skeptical about the inflation targets. Additionally, the price distortions are higher at higher interest rate levels. This could lead to misallocation of resources that could...

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