Many economists have suggested over the past few years that there are essentially two policies that would help the developed countries out of their present situation of large deficits, large sovereign debt and low growth. Many have dared suggest that a combination of financial repression and moderate inflation are the path to salvation. Financial repression occurs when the Fed (Central Banks) maintain an artificially low interest rate . This lowers the burden of servicing the sovereign debt substantially. Ex: If the US national debt of $15 Trillion is to be financed at an average interest rate of say 7% then over a $1 trillion worth of interest will have to be paid each year. If on the other had the average interest rate is to be about 1% then refinancing burden would be only $150 billion i.e. a drop of about $900 billion. That is not bad. What do you think?
Inflation can rise due to either supply or demand-side factors. Because most consumers visualise inflation as a supply-side phenomenon (implicitly holding their own nominal income constant) they see inflation as a problem, not a solution. Thus any calls for a higher inflation target are likely to be highly controversial, which makes it unlikely they would be adopted by conservative central bankers.
A much better solution to frankly admit what a growing number of economists are saying; inflation targeting was a mistake from the beginning, and the major central banks should instead be targeting nominal income growth (preferably level targeting). All of the advantages of higher inflation (economic stimulus, lower real debt loads, etc.) are actually more closely linked to rising nominal incomes. A switch to NGDP targeting would not require the major central banks to adopt a new and higher inflation target, with the associated loss of credibility. Instead they should estimate an NGDP target likely to produce 2% inflation in the long run, that is, an NGDP growth rate target of perhaps 4.5% per year in the US, 4% in Europe, and 2.5% in Japan. If the central bank believes there is a need for some “catch-up growth” (and surely that’s the case in the US and Europe, then they should start the trend line from 2008 or 2009, to allow for higher NGDP growth for the next several years.
Some might argue that this is just a back door way of raising the inflation target. Not so. Inflation targeting is what got us into this mess. If we had been targeting NGDP in 2008, level targeting, then monetary policy would have been far more stimulative, the recession would have been much milder, and the sovereign debt crisis would have been confined to Greece and perhaps one other country. We don’t need an expedient like a temporarily higher inflation target, which will further erode central bank credibility. Rather we need an entirely new policy rule, a rule that will be so robust that it doesn’t have to be abandoned every time we face a recession or a debt crisis. A rule that is consistent with 2% inflation in the long run. Nominal income targeting is the policy rule that is most likely to fit that description.