It would seem that my initial post on raising the inflation target has sparked a pretty fruitful debate. Here’s a quick follow-up by Max on the topic.
I think the case for raising the inflation target is very strong. But it’s especially strong in the context of the European Monetary Union.
You see, the key problem in the Eurozone crisis is “rebalancing”: The periphery countries (the GIIPS) need to reverse their current accounts. And that requires a real devaluation of the periphery vis-à-vis the core (Germany, mainly). My colleague Christoph Zwick reckons in his new working paper that the periphery-core real exchange rate needs to fall by at least 13-17 percent over the next three years. There is, of course, a lot of uncertainty about this estimate. Nevertheless let’s assume a value of 15 percent, which sounds reasonable. This implies an annual real devaluation of (approximately) 5 percent for the next three years. Within the Eurozone, real devaluation can only come through an inflation differential: inflation in the periphery (p) needs to be 5 percentage points below the inflation rate in the core (p*).
Now the ECB targets the Eurozone inflation rate, i.e. the weighted average of core and periphery inflation rates. The share of the core in total Eurozone GDP is about 2/3. Let the ECB’s inflation target be t. So we have t = (1/3)p + (2/3)p*. If you combine this with the requires inflation differential, p* – p = 5, we get p = t – (10/3) and p* = t + (5/3). Hence the periphery inflation rate has to be 3.3 percentage points below the Eurozone target and the core inflation rate has to be 1.7 percentage points above.
An inflation target of 2 percent implies 1.3 percent deflation in the Eurozone’s periphery each year for the next three years. This would be incredibly painful. If the ECB would target 4 percent average inflation, it would allow 0.7 percent inflation in the GIIPS. That also hurts, but probably much less than hardcore deflation. Meanwhile, the new target would imply 5.7 percent inflation in the core countries, which is higher than what we had during the last decade but not at all high by historical standards.
Obviously the concrete numbers are debatable, but the general result is not: Under the ECB’s current inflation target, the necessary current account adjustment in the Eurozone seems pretty impossible. Raising that target would make it a whole lot easier.