IMF rethinks its policy on inflation rates

The International Monetary Fund has long preached the virtues of keeping inflation low and allowing money to flow freely across international boundaries.

But two recent research papers by economists at the fund have questioned the soundness of that advice, arguing that slightly higher inflation and restrictions on capital flows can sometimes help buffer countries from financial turmoil.

One paper has received particular attention for suggesting that central banks should set their target inflation rate much higher – at 4 per cent, rather than the 2 per cent that is the most widely held standard.

As aggregate demand fell across the world in 2008, central banks, including the Federal Reserve, lowered short-term interest rates to nearly zero, where they have largely remained.

While the two papers do not represent a formal shift in the fund’s positions, they suggest that the IMF is re-examining some of its long-established orthodoxies as part of its response to the global economic crisis that began in 2007.

The significant drop in the volatility of output and inflation since the mid-1980s – a period known as “the Great Moderation” – helped lull “macroeconomists and policymakers alike in the belief that we knew how to conduct macroeconomic policy,” the fund’s chief economist, Olivier Blanchard, wrote in the first paper. “The crisis clearly forces us to question that assessment.”
That paper examines how, in hindsight, higher rates would have helped in the current crisis.

“Higher average inflation, and thus higher nominal interest rates to start with, would have made it possible to cut interest rates more, thereby probably reducing the drop in output and the deterioration of fiscal positions,” Blanchard and two co-authors wrote in the paper, released February 12.

The second paper, released Friday, said that in the aftermath of the crisis, officials were “reconsidering the view that unfettered capital flows are a fundamentally benign phenomenon.” “Concerns that foreign investors may be subject to herd behaviour, and suffer from excessive optimism, have grown stronger; and even when flows are fundamentally sound, it is recognised that they may contribute to collateral damage, including bubbles and asset booms and busts,” the fund’s deputy director of research, Jonathan D. Ostry, wrote, along with five co-authors.

Both papers contained important caveats.

Blanchard’s noted that fiscal policy – like decisions to tax, spend and borrow – has been as important in responding to the crisis as monetary policy, or control of the supply of credit.

It argued that governments that had relatively lower debts to begin with had more flexibility to respond to the crisis.

And it asserted that regulatory measures – like requiring higher capital and liquidity ratios, lower loan-to-value ratios for home mortgages, and increased margin requirements for stock purchases – would be more effective than higher inflation targets in curbing excessive risk-taking.

Similarly, Ostry’s report said capital controls would be effective only if the flows “are likely to be transitory” and the economy is already operating near potential, with reserves at an adequate level and an exchange rate that is not undervalued.

The report also found that “the jury is still out” on whether capital controls have worked in practice.

Evidence from countries like Chile and Colombia, it said, suggests that controls have been more effective at curbing exchange-rate pressures and the risk associated with capital inflows than in reducing the net influx of money.