FRBSF Economic Letter
2001-03; February 2, 2001
Inflation: The 2% Solution
By the beginning of the 1980s, double-digit rates of inflation had become
so pervasive among industrialized economies that they were viewed as a
major deterrent to global economic growth. Since then, an explicit policy
goal of low inflation has become a mantra for policymakers, and many countries,
such as the U.K., New Zealand, Australia, Japan, Sweden, and the eleven
countries under the European Central Bank (ECB), have enacted fundamental
reforms to achieve that goal. Specifically, they have made their central
banks more independent and thus insulated them from the temptations of
inflationary finance; furthermore, in most of these cases, as well as
in the U.S., central banks have practiced a greater degree of openness
or transparency about monetary policy decisionmaking to give the private
sector a better opportunity to monitor their activities.
Today, these countries can claim considerable success in reducing both
inflation and inflationary expectations. For example, despite the run-up
in energy prices in 2000, consumer price inflation rates from 1999.Q3
through 2000.Q3 fell to 3.5% in the U.S., to 3.2% in the U.K., to 1.6%
in the EMU countries, to 2.7% in Canada, to 0.9% in Sweden, and to 3.0%
in New Zealand. Japan, with an inflation rate of -1.2%, is something of
a special case, as it is just beginning to emerge from a prolonged recession.
With inflation rates now in the low single digits, attention has become
more narrowly focused on the problem of determining quantitatively what
the "optimal" inflation rate should be. Evidence to date suggests
that policymakers' views have coalesced, however tentatively, around a
"2% solution" to this question. For example, consider these
explicit inflation targets: 2.5% for the Bank of England, less than 2%
for the ECB, 1-3% for the Riksbank in Sweden, 1-3% for the Bank of Canada,
0-3% for the Reserve Bank of New Zealand, and 2-3% for the Reserve Bank
of Australia. While the Federal Reserve has no explicit inflation target,
the U.S. inflation rate has averaged 3.0% since the end of the last recession
in 1991.Q2. This Economic Letter addresses the question: How well
is a "2% solution" to the inflation problem supported by the
voluminous academic studies that have been conducted recently on the optimal
rate of inflation?
The Friedman Rule and the benefits
of 0% inflation
Milton Friedman (1969) described the optimal inflation rate as one that
would not penalize households for holding monetary assets that bear no
interest. This would require a zero nominal interest rate, such that the
real return on money, which is the negative of the inflation rate, would
exactly equal the real return on real assets. This so-called Friedman
Rule has resurfaced in recent theoretical models. These models examine
in an internally consistent manner how inflation leads to the inefficient
use of the economy's resources, and they quantify the significance of
these inefficiencies by taking the models to the data.
Using the Friedman Rule as a benchmark, the standard measure of welfare
losses associated with inflation is computed to be the percent change
in the household's consumption (or income) flow that the household would
require to be indifferent between two inflation rates. The majority of
the large number of theoretical studies devoted to this issue have produced
estimates of the welfare costs of moderate inflation, say, of increasing
the inflation rate from 0% to 10% that fall in the range of approximately
1/3% to 1-1/2% reduction in the household's consumption (or income) flow.
Economists have estimated the magnitude of these welfare costs in several
ways. Early studies (for example, Cooley and Hansen 1989) focused on inflation
as a tax on consumption expenditures associated with monetary transactions;
they found these costs to be toward the lower end of the range reported
above. However, inflation induces additional distortions that raise the
welfare costs. For example, the avoidance of inflation taxes also can
divert resources away from production and into the payment system in order
to increase the velocity of money. This response to higher inflation can
take many forms, from households making more frequent trips to the bank
or ATM machine, to firms devoting greater quantities of capital and labor
toward enhancement of the efficiency of their cash management practices,
to the emergence of nonmonetary systems (often relying on electronic funds
transfers) as a means of effecting final settlement of transactions. As
inflation rises, more of the economy's resources flow into transacting
via these channels and less is available for production, thus reducing
output and consumption and lowering welfare. In addition, higher expected
inflation induces higher nominal interest rates. When firms must borrow
against current sales revenues to finance their working capital expenses,
i.e., their wage bill and/or their gross investment, or when households
borrow against current income to finance the purchase of durable goods,
then the higher financing costs can reduce the amount of working capital
employed by firms and the volume of consumer durables purchased by households,
and again reduce consumption and lower welfare.
From a different perspective, Feldstein (1999) attempted to measure systematically
the costs of inflation with respect to its effect on the rate of economic
growth. He was particularly interested in the costs of low inflation and
took the 2% solution as his benchmark against which he compared an environment
of price stability, or zero inflation. He found relatively small direct
effects of forgone interest income associated with holding noninterest-bearing
monetary assets, but instead focused on the interaction of inflation with
other distortionary measures in the tax code, including capital and labor
income taxes and the home mortgage deduction. After accounting for the
lost government revenue from seigniorage, he obtained hefty estimates
of an approximately 1% reduction in the flow of income (GDP) associated
with an increase in the inflation rate from 0% to 2%.
Other researchers also have advanced the argument that a long-run average
inflation rate of zero would lead to the most efficient allocation of
the economy's resources. Their argument is premised on the view that ours
is a dynamic economy in which the types of products that are produced
and consumed, as well as the means of production, are constantly changing.
For the "invisible hand" of the marketplace to work in this
environment, many decisions must be made at the microeconomic level of
the firm and the consumer. When the long-run average inflation rate is
zero, the aggregate price level is fixed, so any change that is observed
in individual goods prices can be attributed with assurance to a change
in relative prices. These relative price changes are the signals that
firms must rely on to make their production, inventory accumulation, and
factor employment decisions, and that households must rely on in selecting
their consumption bundles or investment portfolios. Aggregate price inflation
confuses this relative price signal and creates uncertainty that can result
in suboptimal decisions by firms and households that induce inefficiencies
in the transformation of the economy's resources into valued output goods.
The result is a decline in welfare.
Are there benefits to inflation?
The above arguments suggest that the "2% solution" to the inflation
problem is not optimal. They support the view that central banks' long-run
inflation goals should be either price stability (zero inflation) or some
mild deflation. Yet some economists argue that there is a rationale for
adopting policies that support positive inflation in the long run.
When the economy experiences an adverse supply shock, such as an oil
shortage, that reduces the productivity of labor, the efficient economic
response in the labor market, when households and firms are fully informed
and make fully rational decisions, is a decline in both the level of employment
and the real wage rate. Some economists have argued that nominal wages
are inflexible downward, and that this rigidity can inhibit the real wage
from falling when prices are stable. As a result, the response, say, to
a negative supply shock would be a larger decline in employment than would
be deemed optimal. In this case, a policy of positive inflation would
allow real wages to fall, even though the nominal wage did not, thereby
enabling employment to absorb less of the shock. Akerlof, et al., (2000)
have argued further that in an environment of low inflation, nominal wages
also may be inflexible upward in the short run, as households enter into
labor contracts that have no provisions for inflation. In this case, real
wages erode with inflation over the life of the contract and economy-wide
employment is higher under moderate rates of inflation than it would be
under a stable price environment.
Critics of these views have countered that these stories are inconsistent
with rational behavior on the part of households, since they imply that
households are more willing to accept real wage declines through higher
inflation than through a lower nominal wage, when rationality would dictate
indifference. They also imply that firms lack the ability to adjust labor
costs without altering the nominal wage. Nonetheless, to the extent that
this short-run rigidity in nominal wages is immune to these criticisms,
benefits to mild inflation may exist, although no studies currently reveal
whether these benefits are sufficiently large to offset the additional
welfare losses from higher inflation as described above.
Finally, the optimal deflation implied by the Friedman Rule would require
a zero nominal interest rate, which in practice is a lower bound with
which economies have had little experience. Japan is perhaps a notable
exception. However, the severity of Japan's banking crisis with an extraordinary
volume of bad loans, and the realization of the need for major structural
reforms within the financial sector that have accompanied the Bank of
Japan's "zero interest rate" policy produces a cloud over any
conclusions that one might be tempted to draw from that experience. Nonetheless,
if the benefits of reducing the swings in the business cycle are perceived
to be large, then central banks would need the flexibility to lower the
interest rate to avoid recession. For example, if the real (inflation-adjusted)
interest rate in the economy is 3%, and if the maximum amount by which
the central bank would anticipate ever having to cut interest rates (below
their long-run averages) is 2%, then the goal of keeping inflation as
low as possible would suggest a 1% deflation on average. If the real interest
rate is believed to be lower, or if the monetary authorities need greater
flexibility to cut interest rates in times of economic weakness, then
the optimal long-run average inflation rate would increase accordingly.
Conclusion
Over the past 20 years, nearly all industrialized economies around the
world have concluded that high inflation is detrimental to their economies
and to the welfare of their citizens. They have taken concrete steps to
lower the inflation rate and to ensure that it remains low. The question
that many are grappling with is how low should they go? The evidence suggests
that there is a perhaps tentative coalescence of views around the choice
of 2%. Research to date would support further reductions in the inflation
rate to zero or to a mild deflation. However, further research is needed
both on the functioning of economies at near-zero nominal interest rates,
as emphasized recently by Lucas (2000), and on the nature and influence
of various types of contractual arrangements, including financial as well
as labor contracts, around which an important share of economic activity
is organized. The results of this research may enhance the arguments for
an outcome closer to the "2% solution," but in any case is likely
to suggest that a refinement of these inflation goals is called for.
Milton Marquis
Senior Economist, FRBSF, and
Professor of Economics,
Florida State University
References
Akerlof, George A., William Dickens, and George Perry. 2000. "Near
Rational Wage and Price Setting and the Long Run Phillips Curve."
Brookings Papers on Economic Activity 1, pp. 1-44.
Cooley, Thomas E., and Gary D. Hansen. 1989. "The Inflation Tax
in a Real Business Cycle Model." American Economic Review
79 (September) pp. 733-748.
Feldstein, Martin. 1999. "Capital Income Taxes and the Benefit of
Price Stability." In The Costs and Benefits of Price Stability,
ed. Martin Feldstein, pp. 9-43. Chicago: NBER.
Friedman, Milton. 1969. The Optimal Quantity of Money and Other Essays.
Chicago: Aldine.
Lucas, Robert E., Jr. 2000. "Inflation and Welfare." Econometrica
68 (March) pp. 247-274.
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