The primary objective of most of the world's central banks these days is to keep inflation low, and the range of inflation rates banks find acceptable appears to be around 2.5 to 3.5 percent. While banks may have hit on this range through trial and error, economic theory and empirical observations suggest a good reason for it.Inflation (Finance) ; Banks and banking, Central

David E. Altig

English

Research Papers in Economics

desire to avoid both high and very low
inflation (or deflation) out of a common
story about how the economy works. 
  Why Low Inflation? Some
Usual Suspects
Why has the behavior of central banks—
and the social consensus that supports
that behavior—converged on the appar-
ent belief that average rates of inflation
should not exceed the lower half of sin-
gle digits? The classic view is that infla-
tion is bad because it wastes resources,
and therefore low inflation is better than
high. Economic textbooks often list
three problems associated with inflation:
hyperinflation, uncertainty, and so-called
“shoe-leather” costs. But does the desire
to avoid these costly problems convinc-
ingly explain the acceptable range of
inflation modern central banks have 
settled on?
The costs of hyperinflation seem obvi-
ous, but appeals to hyperinflationary
episodes are hardly informative about
the choice between moderate inflation—
say annual rates in the 10–15 percent
range—and the quite low rates favored
by today’s central bankers. Similarly, it
isn’t hard to understand the problems
that can arise with volatile and unpre-
dictable price-level fluctuations, but that
doesn’t explain why anticipated inflation
is of any concern. (Although it is well
known that the level and variability of
September 15, 2003
Federal Reserve Bank of Cleveland
What Is the Right Inflation Rate?
by David E. Altig
ISSN 0428-1276
The primary objective of most of the
world’s central banks these days is to
keep inflation low, and the range of
inflation rates banks find acceptable
appears to be around 2.5 percent to 
3.5 percent. While banks may have hit
on this range through trial and error,
economic theory and empirical obser-
vations suggest a good reason for it. 
One of the most striking global policy
developments of the past 40 years must
surely be the emergence of price stabil-
ity as the predominant mandated objec-
tive—in many cases, the only long-run
objective—of modern central banks.
The list of major countries that have for-
malized their objectives as explicit infla-
tion targets includes the European Cen-
tral Bank (ECB) and the central banks of
Canada, New Zealand, Sweden, and the
United Kingdom. It is no secret that
important voices within the Federal
Reserve have expressed the desirability
of adopting such targets in the United
States. (See, for example, Governor Ben
Bernanke’s speech “A Perspective on
Inflation Targeting.”)
In those countries that do explicitly
announce desired rates of price-level
growth, the similarity of the chosen
ranges is striking. The target range is cur-
rently 1 percent to 3 percent annually for
both Canada and New Zealand and 1.5
percent to 2.5 percent in Sweden. The tar-
geted inflation rate in the United King-
dom is 2.5 percent. It is obvious, then,
that inflation-targeting central banks are
loath to tolerate inflation that is too high
and that the operational definition of too
high is north of about 3 percent. 
Just as notable is the apparent unwilling-
ness to tolerate price-level growth that is
too low. Most of the central banks with
explicit inflation targets set lower limits
that are well above zero. Even those that
officially set no lower limit seem to have
one in mind. The ECB, for example,
does not specify a minimum inflation
target, but Ottmar Issing, a member of
the bank’s executive board, has argued
that the ECB’s objective “was clearly
intended from the start to mean neither
prolonged inflation nor prolonged defla-
tion.” Issing adds that “the experience
and analyses of recent years have shown
that … inflation and interest rate levels
excessively close to zero entail risks of
deflation and reduce the scope for mone-
tary policy action.”1
Few doubt that central bankers in the
United States share much of the senti-
ment that is formalized among inflation-
targeting central banks. Since the last
significant break in the U.S. inflation
trend in the early part of the past decade,
annual CPI inflation rates have not been
allowed to exceed 3.5 percent. On the
other hand, it is just as clear that there
are limits to how far Fed policymakers
are willing to go in reducing the average
pace of price-level growth. Recent
speeches by Bernanke and Federal
Reserve Bank of Richmond President Al
Broaddus are testimonials to an aversion
by Federal Open Market Committee
members to declining price levels. The
consensus across the world’s major cen-
tral banks, then, seems to be that infla-
tion ought to be low, but not too low. 
Why is the “right” inflation rate low, 
but not too low? In this Economic 
Commentary I review some empirical
evidence and sketch some economic 
theory that together provide a potential
answer to this question. The analysis I
present is based on the work of our late
friend and colleague Bruce D. Smith. 
To be sure, there are answers to the ques-
tion of what the right inflation target
should be that I will not cover in this
short article. On the not-too-high end of
the spectrum, some economists, such as
Harvard’s Martin Feldstein, have empha-
sized interactions with nominally based
capital-income taxation. On the not-too-
low end, many economists note that
measurement problems may result in
calculated inflation rates overstating the
true rates. In most cases, these argu-
ments, and others, complement the the-
ory and evidence I will discuss here. But
the work of Bruce and his coauthors has
the distinct advantage of describing theinflation are highly correlated, the
explanations as to the source of this
connection are seldom offered.)   
That leaves shoe-leather costs, the
resources that are employed to mini-
mize money balances in an inflationary
environment (and hence minimize the
costs of declines in the purchasing
power of money). These costs, of
course, should be interpreted broadly,
including, for example, the vast
resources that corporations devote to
financial management. But surely diffi-
culties with cash management cannot
begin to explain why a policymaker
would prefer, say, 2
1/
2 percent inflation
to a perfectly predictable pace of 
10 percent.
  Why Low Inflation?
Another Case
An empirical case for preferring 
2
1/
2  percent price-level growth to an 
average rate near 10 percent can be 
supported by two key observations. First,
the existence of a well-developed and
smoothly operating process of financial
intermediation is a key contributor to
economic growth, and second, high 
inflation interferes with intermediation. 
The term “financial intermediation” just
describes the function of getting
resources from the pockets of savers
into the hands of borrowers, such as
firms and entrepreneurs. To observe that
financial intermediation is a key to
growth is to say that countries with a
robust banking system, broad equity
markets, and deep capital markets are
on average more prosperous than coun-
tries without.   
It is possible, of course, that the associa-
tion between financial intermediation
and economic growth merely reflects
the fact that financial market activity is
naturally larger in economies with more
economic activity. But careful statistical
analysis suggests that the causation
works both ways; while higher GDP
growth does drive financial intermedia-
tion, financial intermediation, at least in
part, drives output growth, too. 
The second key observation, that high
inflation interferes with the process of
financial intermediation, is illustrated in
figure 1. Figure 1 plots, for a variety of
countries over the period from 1960 to
1995, a measure of average financial
market activity—the sum of lending to
the private sector and equity market
capitalization to be precise—against
annual average inflation rates. The rela-
tionship, as the chart indicates, is nega-
tive, indicating that higher rates of infla-
tion are associated with lower levels of
financial market activity. 
Why think high inflation is responsible
for the low level of financial market 
performance? The theoretical basis for
believing so centers on the proposition
that high inflation rates result in low
returns to capital and hence diminished
incentives to save and invest. The problem
is particularly acute when collateral is
required for the efficient functioning of
borrowing and lending markets. Too little
saving inhibits the accumulation of collat-
eral, thereby inhibiting growth-enhancing
financial intermediation. (See “Taking
Financial Intermediation Seriously” for a
detailed exposition, that is, a tractable
mathematical model, of the theory. )
How high is too high? Careful analysis
of evidence like that shown in figure 1
suggests that, for developed countries,
that answer is less than 5 percent. In
other words, the empirical ceiling above
which inflation appears to be harmful to
economic performance is about equal to
the upper bound chosen by inflation-
targeting central banks, plus a few 
percentage points for cushion. 
  Why Not Too Low?
This, of course, leaves the second aspect
of central bank behavior yet unex-
plained. If less than 5 percent is suitable
for maximum sustainable growth, why
not go all the way to zero? Why not 
negative rates of inflation? Why do 
central banks that seek to avoid even
moderately high rates of inflation also
appear reluctant to engineer rates of
inflation that are too low? 
The casual answer to this question is that
deflation is a bad thing, and the lower the
rate of inflation, the more likely it is that
the economy may spend extended periods
of time in periods of falling prices. But
this can only be part of the answer. Indeed,
it is far from obvious that deflation per se
is problematic. (See the Federal Reserve
Bank of Cleveland’s 2002 Annual Report.)
A comparison of China and Japan over
the second half of the 1990s and into the
turn of the millennium offers an instruc-
tive example. As appears clear from
glancing at figure 2, the inflation experi-
ences of the two countries over this
period are remarkably similar. In fact,
from 1997 through 2002, the average
inflation rate for consumer prices in both
Japan and China was, for practical 
purposes, zero (slightly positive in
China, slightly negative in Japan.) 
The growth performances of GDP, on
the other hand, were as different as the
inflation rates were similar. Over the
period extending through 2000 (the lat-
est for which we have final Chinese
data), the Japanese economy grew at an
average rate of under 1 percent. The
Chinese economy, in contrast, grew by
nearly 8 percent per year. So here is an
example of two economies, with very
low average inflation rates, both experi-
encing periodic deflations. And yet one
struggles while the other thrives. What
distinguishes one from the other?
A clue can be found in the real returns to
capital in each country. Figure 3 shows
real interest rates for the two countries,
again from 1997 through 2002. Here the
comparisons mirror the GDP growth
differences. Real, inflation-adjusted
returns over the period are fairly high 
in China—between 5 percent and 
10 percent—and quite low in Japan—
ranging from zero to about 3 percent.
It is in low real interest rate environments
—typical of mature, highly capitalized
economies like Japan (especially in
downturns or slow growth periods)—that
deflation is most likely to be problematic.
There are two views on why this might
be so. In the first, most conventional
view, the capacity of monetary policy to
stimulate the economy requires the abil-
ity to lower short-term interest rates as a
way to influence the whole spectrum of
rates that determine spending on goods
and services. Once short-term nominal
interest rates fall all the way to zero, so
the story goes, this specific channel of
policy influence becomes tenuous
(because nominal interest rates cannot, in
normal circumstances, be driven into
negative territory). In this case, low infla-
tion rates are problematic if they make it
more likely that the zero bound on inter-
est rates will be hit. (On this problem,
however, see Bernanke’s comments in 
his “Deflation...” speech.)  
A less familiar, but perhaps more trou-
bling view builds on the connection
between growth and financial market
activity, discussed above as a justifica-
tion for avoiding inflation rates that are
too high. In this view, low nominal
interest rates weaken the incentives of
banks, for example, to lend. In the
absence of active participation by finan-
cial institutions in the process of chan-neling funds to borrowers, the capacity of
the economy to expand can be hindered,
perhaps severely. 
This idea is really just a variant of a famous
result in monetary macroeconomics known as
the Mundell-Tobin effect. Named for Robert
Mundell and James Tobin, the two Nobel
Prize winners credited with the idea, the
Mundell-Tobin effect derives from the notion
that money should be thought of as an alterna-
tive asset to claims on physical capital. The
implication for the present discussion is that,
over some range, the return to capital may be
so low that the incentives of banks and other
financial intermediaries to lend, rather than
simply accumulate “cash,” becomes negligi-
ble. Such a circumstance is most likely when
price-level growth is low or negative, because
the return to money rises as the pace of 
inflation falls. 
This view of the potential dangers of low
inflation carries with it two critical policy
implications. First, problems may arise well
before nominal interest rates actually hit
zero—the interest rate that is too low is the
one at which financial intermediation
stalls—and (if real interest rates are low
enough) well before inflation rates actually
enter negative territory. Second, strategies
such as targeting long-term interest rates if
short-term rates fall to zero, or close to it,
will be counterproductive unless they result
in an increase in expected inflation, and
hence nominal interest rates, to levels high
enough to prompt the reemergence of finan-
cial market lending.
Empirical evidence does in fact suggest that,
at very low rates of inflation, a little higher
price-level growth may be preferable to a lit-
tle lower. Specifically, looking over a cross-
section of countries that includes those with
both high and low rates of price-level growth,
there appears to be a positive association
between growth and inflation, as long as the
rate does not move beyond the 5 percent
threshold associated with deteriorating long-
term growth.
  Institutional Wisdom?
The proposition that high rates of inflation are
detrimental to long-run economic perfor-
mance is no longer a matter of serious dispute.
It is simply not possible to contemplate global
macroeconomic history over the past 40 years
without concluding that central bankers have
converged on the belief that average annual
price-level growth ought not exceed a lower
single-digit pace. The success enjoyed in con-
taining inflation to these levels would make it
inevitable that the question of whether infla-
tion can be too low would eventually come to
the table. It has, and the behavior of central
NOTE:  FD1 is the sum of lending to the private sector and equity market capitalization for each of the countries
included.
SOURCE:  “Inflation and Financial Depth,” by Mohsin S. Khan, Abdelhak S. Senhadji, and Bruce D. Smith,
International Monetary Fund Institute, Working Paper 0144, and “A New Database on Financial Development
and Structure,” by Thorsten Beck, Asli Demirguc-Kunt, and Ross Levine, unpublished manuscript (data provided
by the authors).
FIGURE 1 FINANCIAL DEPTH AND INFLATION
FD1
0
50
100
150
200
250
–60 –40 –20 0 20 40 60 80 100 120
Inflation
FIGURE 2 GROWTH AND INFLATION IN CHINA AND JAPAN
FIGURE 3 REAL INTEREST RATES IN CHINA AND JAPAN
–2
0
2
4
6
8
10
1995 1997 1999 2001
Percent
Consumer Price Index
Real GDP
JAPAN GDP and CPI
–2
0
2
4
6
8
10
1995 1997 1999 2001
Percent
Cost of
Living Index
Real GDP
CHINA GDP and CPI
–20
–15
–10
–5
0
5
10
15
1991 1993 1995 1997 1999 2001 2003
Percent
China
Cost of Living Index
China : Prime Lending Rate -
–3
–2
–1
0
1
2
3
4
5
1995 1997 1999 2001
Percent
JAPAN
Deposit Rate NSA–
Cost of Living Index
Prime Lending Rate–
Cost of Living Index
CHINA
Lending Rate–CPI
Deposit Rate–CPI
SOURCE:  International Monetary Fund, International Financial Statistics.
SOURCE:  International Monetary Fund, International Financial Statistics.Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
Return Service Requested:
Please send corrected mailing label to
the above address.
Material may be reprinted if the source is
credited. Please send copies of reprinted
material to the editor.
David E. Altig is a vice president and the
associate director of research at the Federal
Reserve Bank of Cleveland. 
The views expressed here are those of the
author and not necessarily those of the Federal
Reserve Bank of Cleveland, the Board of 
Governors of the Federal Reserve System, or
its staff. 
Economic Commentary is published by the
Research Department of the Federal Reserve
Bank of Cleveland. To receive copies or to be
placed on the mailing list, e-mail your request
to 4d.subscriptions@clev.frb.org or fax it to
216-579-3050. Economic Commentary is also
available at the Cleveland Fed’s site on the
World Wide Web: www.clev.frb.org/research,
where glossaries of terms are provided.
We invite comments, questions, and sugges-
tions. E-mail us at editor@clev.frb.org.
PRSRT STD
U.S. Postage Paid
Cleveland, OH
Permit No. 385
bankers the world over seems to speak to
the conclusion that the answer is it can. 
On the basis of observing central bank
decisionmaking today, the dominant
definition among monetary policymak-
ers of the “right” inflation goal seems
to be somewhere between 1 percent and
4 percent. To be sure, the book on this
subject is far from closed. But as we
confront this conclusion with economic
theory and real-world evidence, the
sense of today’s central bankers looks
more and more like wisdom.
  Recommended Reading
Ben S. Bernanke, 2003, “A Perspective
on Inflation Targeting,” speech deliv-
ered at the Annual Washington Policy
Conference of the National Association
of Business Economists, Washington,
D.C., March 25. Available at
<www.federalreserve.gov/boarddocs/
speeches/2003/20030325/default.htm>.
J. Alfred Broaddus, 2003, “Comments on
Monetary Policy in a Low Inflation Envi-
ronment,” remarks to the Public Policy
Forum, American Finance Association,
Washington, D.C., January 3. Available 
at <www.rich.frb.org/media/speeches/pdf/
ab2003-1.pdf >.
Federal Reserve Bank of Cleveland,
2003, “Deflation,” essay in the 2002
Annual Report.
Ben S. Bernanke, 2002, “Deflation:
Making Sure ‘It’Doesn’t Happen
Here,” remarks delivered before the
National Economists Club, Washington,
D.C., November 21. Available at
<www.federalreserve.gov/boarddocs/
speeches/2002/20021121/default.htm>.
Bruce D. Smith, forthcoming, “Taking
Financial Intermediation Seriously,”
Journal of Money, Credit, and Banking. 
On credit market imperfections:
O. Emre Ergungor and Joseph G.
Haubrich, 2003, “Information and
Prices,” Federal Reserve Bank of Cleve-
land, Economic Commentary, May 1.
  Footnotes
1. “ECB Watchers Conference: Monetary
Policy and the Role of the Price Stability
Definition,” www.ecb.int/key/02/
sp020610.htm. 

What is the right inflation rate?

http://www.clevelandfed.org/Research/commentary/2003/0915.pdf

What is the right inflation rate?

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics