The IMF argues that a low rate of inflation limits the scope of monetary policy in a downturn by putting an effective floor under the real, inflation-adjusted interest rate that central banks can use to stimulate economic activity. Negative real interest rates can help speed recovery, but since nominal rates can’t fall below zero, a central bank can push real rates into negative territory only as far as the amount of current or expected inflation. A -2% real interest rate, for instance, requires at least 2% inflation (if the nominal rate was zero).

 

Japan is currently facing this problem. Although the Bank of Japan lowered its overnight call rate to 0.1% in December 2008, the onset of deflation means the real cost of borrowing has risen. This is discouraging investment and hurting borrowers by increasing the real value of their debts. A policy targeting higher inflation could have avoided this situation, by increasing the efficacy of low nominal interest rates and by reducing the likelihood of a lapse into deflation in the first place.

 

The IMF notes that the Taylor rule—a widely used tool for estimating where the fed funds rate in the U.S. should be—suggests that a real interest rate between -3% and -5% would have been appropriate in late 2008, given the U.S. economy’s large output gap. Yet with inflation in the U.S. at 2%, the lowest real rate the Fed can achieve, even at a nominal zero rate, is -2%.

 

Arguments for higher inflation are controversial, to say the least, and threaten to dislodge a decades-old macroeconomic policy consensus. Critics of the IMF position note that inflation is regressive, hurting those living on fixed or low incomes, while benefiting those who have the ability to hedge against rising prices, typically the wealthy. Yet this problem can be alleviated through policies such as a negative income tax for those at the low end of the income scale.

 

Critics also worry that a higher inflation target will encourage more asset bubbles like the property boom that preceded the financial crisis. But managing asset markets is arguably already beyond the ability of a central bank working with just a single policy rate. Indeed, countries with a wide variety of benchmark interest rates saw rapid increases in house prices in the years leading up to 2008.

 

For this reason, the IMF advocates adding countercyclical regulatory tools to the central bankers' kit. Policymakers should be able to target activity in specific markets, imposing higher loan-to-value ratios for mortgages if housing heats up, higher bank reserve ratios to curb excessive lending growth, or higher margin requirements if stock prices appear irrationally exuberant.

 

Such rules can be tightened or relaxed to lean against the business cycle. Yet undertaking to smooth asset prices leads to questions regarding a central bank's ability to determine the "correct" price of assets. One offsetting argument is that central banks are in the business of smoothing output. Making similar judgment calls about asset markets, which they already watch closely, should not be radically different.

 

But while there are theoretical benefits to higher inflation targets, the IMF will have a tough time convincing central bank heads in the developed world. “I don’t agree at all with what the IMF paper said,” Reserve Bank of Australia governor Glenn Stevens declared in a recent parliamentary hearing.