Could a higher inflation target enhance macroeconomic stability?

Summary

Focus

Prior to the 2007-09 Great Financial Crisis, an inflation target of 2% was viewed as high enough to make the effective lower bound (ELB) constraint on nominal interest rates largely irrelevant. This view is now questioned in the light of two important developments. First, in the aftermath of the financial crisis, the ELB proved to be a more persistent and severe constraint than anticipated. Second, the real neutral rate has fallen, implying lower nominal interest rates and less scope for conventional monetary policy easing in response to shocks, given the 2% target. Motivated by these developments, we study the extent to which raising the inflation target to 3% or 4% could improve macroeconomic stability in Canada.

Contribution

First, we consider different assumptions about the level of the real neutral rate. Second, we take into account the possibility that the central bank can make systematic, rule-based use of the two most prevalent types of unconventional monetary policy (UMP) at the ELB: forward guidance and quantitative easing. Third, our analysis is carried out in the Bank of Canada's main policy model, which provides a quantitatively realistic description of the Canadian economy.

Findings

We find that when the real neutral rate is positive, UMP essentially eliminates most gains of raising the inflation target to 3% or 4%. On the other hand, if the real neutral rate is negative, an increase in the inflation target provides substantial macroeconomic benefits by reducing the impact of the ELB on the output gap and inflation, regardless of the availability or effectiveness of UMP. We also find that forward guidance is more powerful when the real neutral rate is sufficiently high, while quantitative easing becomes more effective if the real neutral rate is negative.

Abstract

Recent international experience with the effective lower bound on nominal interest rates has rekindled interest in the benefits of inflation targets above 2 per cent. We evaluate whether an increase in the inflation target to 3 or 4 per cent could improve macroeconomic stability in the Canadian economy. We find that the magnitude of the benefits hinges critically on two elements: (i) the availability and effectiveness of unconventional monetary policy (UMP) tools at the effective lower bound, and, (ii) the level of the real neutral interest rate. In particular, we show that when the real neutral rate is in line with the central tendency of estimates, raising the inflation target yields some improvement in macroeconomic outcomes. There are only modest gains if effective UMP tools are available. In contrast, with a deeply negative real neutral rate, a higher inflation target substantially improves macroeconomic stability regardless of UMP.

JEL classification: E32, E37, E43, E52

Keywords: inflation target, effective lower bound, unconventional monetary policy, quantitative easing, forward guidance