Olivier Blanchard on the Case for Higher Inflation

Add the IMF’s Olivier Blanchard to the list of economists who thinks central banks should rethink their commitment to super-low inflation:

IMF survey online: Central banks have chosen low inflation targets, around 2 percent. In your paper, you argue that maybe we should revisit this target. Why?

Blanchard: The crisis has shown that interest rates can actually hit the zero level, and when this happens it is a severe constraint on monetary policy that ties your hands during times of trouble.

As a matter of logic, higher average inflation and thus higher average nominal interest rates before the crisis would have given more room for monetary policy to be eased during the crisis and would have resulted in less deterioration of fiscal positions. What we need to think about now if whether this could justify setting a higher inflation target in the future.

Another factor that I think is worth taking seriously, is that it seems to me that very low inflation leads people to save too little. Most people suffer from some degree of “money illusion” so with inflation at 2 percent both the cost of borrowing money and the return to saving money appear lower than they would with inflation at 4 percent.