IMF's Blanchard and higher inflation

Olivier Blanchard is a leading MIT macroeconomics economist who is now the chief economist for the IMF. In a recent policy position piece for the IMF, Rethinking Macroeconomic Policy SPN 10/03, Blanchard reviewed the current state of macroeconomics discussing the pros and cons of monetary, fiscal and regulatory policy on the objective of reaching full employment. While much of what he stated is well accepted as conventional wisdom. There is one area that causes a raised eyebrow.

He suggested that banks should raise their inflation targets from 2 to 4% as one idea to get the global economy going again both for today and over the longer-run. By raising the inflation targets, the chance of a zero interest rate problem is reduced. This was suggested as one of the main problems with the global monetary environment.

This simple policy will force inflation expectations higher through more aggressive monetary policy. Raising inflationary expectations will force money out of cash accounts and into the lending markets at higher rates. The end of deflation and liquidity traps will lead to more current activity and reduce the pressure on lenders. Of course, creditors would be hurt. Government debt would be educed in nominal terms which offsets some of the deficit problem. Good idea?

Central banks have spent 20 years trying to control the inflation excesses of the the later 70's and early 80's. They were successful by increasing their creditability through forcing targets upon themselves. This has been good for many economies and have reduced the cost of inflation even at low levels.

The objective of inflation targets is not to eliminate inflation or allow for deflation but to have a controlled low volatility environment. A new policy target would change the equilibrium between central bank policy and inflation expectations to a higher rate.

Unfortunately, there would be costs with change the equilibrium inflation target. Risk premiums would increase and it is not clear that inflation could be contained at 4%. There is the underlying assumption that we can handle an extra 2% of inflation. The cost of 4% inflation is low, or from the policy perspective the cost of inflation is low relative to the cost of being constrained by an zero nominal rate. Ask that to those who are bond holders or on fixed pensions. I agree this will solve constraints on policy-makers, but I am having a hard time finding where the brilliance is in the provocative idea from an investors point of view.