Targeting from Below

Inflation targeting (IT) was widely adopted by central banks in both industrialized and emerging-market countries in the 1990s and 2000s. Typically, the objective for switching to an IT framework has been to reduce and stabilize high and volatile inflation. Studies of IT find that it has been successful in regards to this objective.

But how does IT fare when inflation is instead too low? Michael Ehrmann of the Bank of Canada addresses this question in "Targeting Inflation from Below: How do Inflation Expectations Behave?" He notes that the Bank of Japan adopted IT in an environment of undesirably-low inflation. Likewise, when the Federal Reserve announced a 2% inflation target in 2012, core inflation had been below 2% for some time. "Although designed to lower inflation and inflation expectations," Ehrmann writes, "IT is now charged with the objective to raise them, a challenge that has not yet been studied extensively."

Since inflation targeting is supposed to work by anchoring expectations near the target, Ehrmann studies the inflation expectations of professional forecasters to compare the performance of IT when inflation is persistently low, near target, and persistently high. He uses data from Consensus Economics for Australia, Canada, the euro area, France, Germany, Italy, Japan, the Netherlands, New Zealand, Norway, Spain, Sweden, Switzerland, the United Kingdom and the United States. He uses three different indicators of the extent to which inflation expectations are anchored: (1) the extent to which expectations depend on lagged inflation; (2) forecaster disagreement; and (3) the extent to which inflation expectations get revised in response to news. On all three counts, he finds that under persistently low inflation, expectations can become disanchored. That is, inflation expectations are more dependent on lagged inflation; forecasters disagree more; and inflation expectations get revised down in response to lower-than-expected inflation. He also finds that when inflation is persistently low, expectations do not get revised upward in response to higher-than-expected inflation.

These findings are important. We tend to worry about inflation expectations becoming disanchored when inflation goes too high above target or stays above target for too long. This is partly why the inflation target gets treated more like a ceiling than a symmetric target. But in the current situation in the U.S. and Europe, it may be that keeping inflation too low is weakening the anchoring of expectations. A temporary burst of above-target inflation seems unlikely to damage the anchor.