Life is full of things you don’t want too little or too much of. Coffee is a classic example: without a dose of caffeine, many cannot imagine waking up in the morning. But drinking too much of it easily leads to unwanted hyperactivity.
It is not so easy to say how many cups of coffee are just right. It’s the same with inflation. If it is too low, it can lead to a spiral of debt. If it is too high, redistributions and inefficiencies occur that are perceived as unfair. But where exactly the optimal inflation lies, no one can define.
Nevertheless, the US Federal Reserve and the European Central Bank have set an inflation target of two percent. At first glance, this worked quite well for the USA and the euro zone, because annual inflation has averaged 1.97 percent since monetary union came into existence – spot on.
Things are looking similarly good for the USA. But as with averages, if the hunter misses a rabbit once to the right and once to the left, he has hit it on average.
In the years following the financial market crisis of 2008, the euro zone fell well short of its inflation target for more than ten years, while it has been massively exceeded for more than a year.
Structural factors are at work here, most notably in the form of a global turning point in demographics. The rising proportion of the non-working population means an increasing shortage of labour.
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This strengthens the bargaining power of workers and increases price pressure through higher wage increases. completely independent of the corona crisis or the Ukraine war. Since there are also cost drivers such as deglobalization and climate protection measures, the inflation target of two percent can be expected to be exceeded in the long term.
You could also say that the previous two cups of coffee in the morning now have to be increased to three cups because the caffeine content of the coffee has decreased. So if structural factors keep inflation pushing towards three or four percent, it makes little sense for the central bank to constantly put the brakes on and trigger recurring recessions.
Central banks have to be careful not to keep stepping on the brakes and risk a recession in the future
Rather, the question is whether the ECB and the Fed should raise their inflation target of two percent. Many market observers urgently warn against such a step. There is talk of a loss of credibility on the part of the central banks and the associated risk that inflation will finally spiral out of control.
Would savers also suffer from a higher inflation target? That depends on how interest rates develop.
These risks should not be downplayed. There can be severe turbulence, especially in the phase in which the financial markets have to adjust to a new inflation target.
Because in this phase, inflation expectations would probably rise sharply, which in turn would lead to a revaluation of the bond markets that would go beyond what we have experienced in the past twelve months.
The weaknesses in the banking sector after the insolvency of the Silicon Valley Bank, which are already revealed by the rise in yields, would become even worse and possibly lead to a new financial market crisis. A sharp increase in interest rates could also be dangerous for highly indebted companies and countries.
Would savers also suffer from a higher inflation target? That depends on how interest rates develop. If inflation levels off at 3% while the ECB’s new equilibrium rate lands at 4%, savers would receive a positive real interest rate on their short-term deposits over the longer term.
Even if there may be brief turbulence, raising the inflation target should pay off in the long run. Because with a higher inflation target of 2.5 to 3.5 percent, a central bank would not have to constantly counteract and risk a recession.
This also puts the argument of loss of credibility put forward by opponents of raising the inflation target into perspective. A central bank that is responsible for a long-term loss of welfare is more likely to come under political and social pressure than one that reacts to structural changes and adjusts the inflation target for the benefit of all.
The author:
Cyrus de la Rubia is chief economist at Hamburg Commercial Bank.
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