Academic journal article Economic Review - Federal Reserve Bank of Kansas City

What Is the Optimal Inflation Rate?

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

What Is the Optimal Inflation Rate?

Article excerpt

In the late 1970s and early 1980s, many countries, including the United States, experienced high inflation. A broad consensus emerged that this performance was unacceptable, and monetary policymakers around the world adopted policies designed to bring inflation down. With inflation undesirably high, policymakers knew what direction they needed to push inflation even if they were uncertain of its ultimate destination.

Now, with inflation much lower in the United States and elsewhere, the question of what inflation rate to aim for has moved front and center. Most policymakers agree they should not allow inflation to fall below zero because the costs of deflation are thought to be high. The decade-long economic slump that accompanied deflation in Japan in the 1990s provides an example of deflations potential for harm.

Policymakers and economists disagree, however, about how much above zero, if any, central banks should aim to keep inflation. One reason for keeping inflation above zero stems from the fact that nominal interest rates cannot fall below zero. When inflation is low and expected to remain low, investors are willing to accept a low inflation premium when purchasing nominal debt instruments. As a result, nominal interest rates will tend to be low. And because central banks counteract slowing economic activity by lowering short-term interest rates, a very low-inflation environment limits the extent to which policymakers can respond to an economic slowdown. Once short-term rates fall to zero, conventional monetary policy tools no longer work to stimulate economic activity.

Knowing what inflation rate to aim for is also critically important because many central banks have adopted formal numerical inflation objectives over the last couple of decades. Setting an appropriate target for inflation requires understanding how alternative inflation objectives impact economic stability and overall economic well-being. Ideally, policymakers should aim for an inflation rate that maximizes the economic well-being of the public. Unfortunately, rigorous estimates of such an "optimal inflation rate" have not been available in the economics literature.

This article provides estimates of the optimal inflation rate. The first section describes why the optimal inflation rate might be somewhat above zero. The second section examines the relationship between alternative inflation objectives and macroeconomic stability, showing quantitatively how the likelihood of hitting the zero nominal interest rate bound is higher for lower inflation objectives. The third section provides estimates of the optimal inflation rate for the U.S. economy.

Based on a standard, modern macroeconomic model calibrated to U.S. data, the inflation rate that is optimal after accounting for the zero bound-but not necessarily all other relevant factors-is estimated to be 0.7 to 1.4 percent per year as measured by the PCE price index. This estimate is the first to be based on an economic model in which policymakers are assumed explicitly to maximize the economic well-being of the public. Further research is required to confirm or refine these results in models that incorporate a richer array of possible interactions between the long-run inflation objective and economic stability.

I. WHY MIGHT THE OPTIMAL INFLATION RATE BE LOW AND POSITIVE?

There is widespread agreement among the public, economists, and policymakers that inflation is bad for the economy. As a result, in recent decades, central banks have adopted policies first to fight inflation and then to keep inflation low. But, for a number of reasons, inflation can be too low. Accordingly, while policymakers want to keep inflation low, they have not typically aimed for zero inflation.

Why should inflation be kept low?

Inflation is costly. When it is unanticipated, it arbitrarily benefits debtors and hurts creditors by decreasing the nominal value of outstanding debt. …

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