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Monday 19 Feb 2018 | 05:30 | SYDNEY
Monday 19 Feb 2018 | 05:30 | SYDNEY

Inflation: The IMF's heresy



16 February 2010 11:47

It's only a few weeks since the IMF renounced its advocacy of 'corner solutions' for the exchange rate: that countries should have either a rigidly fixed rate or a clean float.

Now, their Chief Economist is arguing for a far more radical change. Countries should aim for higher inflation (4 per cent rather than the conventional 2 per cent) so that when a crisis comes, there will be more room to ease monetary policy.

If inflation was routinely running at 4 per cent rather than 2, nominal interest rates would be correspondingly higher. Thus the room for dramatic policy easing in a crisis would be that much greater. Dropping the rate to near-zero (which the crisis countries did in 2008) would be a bigger shift of the monetary policy lever.

Advocating  4 per cent inflation is, however, serious heresy for central bankers, who have struggled for the past couple of decades to establish the framework that allows them to carry out the unpopular function of 'taking away the punch bowl just when the party is getting to be fun'.

A central tenet of this framework is that inflation should be kept at a rate which doesn't distort people's financial decisions, which the usual consensus puts at around 2 per cent. What is being suggested here is that the economy should operate with the distorting inefficiency of 4 per cent inflation in normal times, waiting for the rare times (every few decades) when the authorities want to put monetary policy in an extreme setting.

Just how extreme this setting would be is worth noting. Real (ie. inflation-adjusted) interest rates usually average around 3 percent. An investor who borrows at this sort of rate needs to select the project with care – it must return enough to pay the interest bill and give some profit. Buying an asset whose price just keeps up with inflation is no use.

But with real interest rates substantially negative, the investor's calculation changes: the easy profits are to be made from borrowing at negative real rates and investing in whatever real asset whose price is going to rise along with the target inflation rate. Buying existing assets will look a better bet than employing workers and making new investments.

Full marks to the IMF for using the Global Financial Crisis as a reason for examining conventional policy wisdom: something certainly went seriously wrong. But monetary policy does not seem to be the weak link in handling the crisis. Putting in place more robust financial structures with rigorous and effective supervision would seem to be the first priority. This will be easier to do at low rates of inflation than with the 4 percent advocated here.

Photo by Flickr user mullica, used under a Creative Commons license.

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