Inflation down-but is it what we want?

Sorry for the gap in posting...have been trying to get on top of a whole pile of books that need to be read before the end of the summer!

The Bank of England recently announced that inflation was within its intended target of 2% +/- 1%. It has fallen from 2.8% in May to 2.4%, which is the lowest inflation rate since the end of 2009. However, while this seems like a rest-bite for the Bank, which has come under scrutiny lately for the Libor scandal, do we actually want an inflation target of 2%?

I am currently reading Paul Krugman's End This Depression Now! which suggests that we should actually have an inflation target of 4%, which was actually the rate of inflation during Ronald Reagan's second term in office when he presided over a period of economic recovery, often referred to as "Good Morning America." An inflation target of 4% is not ridiculously high, and fears of hyperinflation and the like are unnecessary.

Over my AS course, I have been taught that inflation is not desirable, and inflation can have serious negative consequences for an economy. However, if you take our current situation as a depression, higher inflation could be desirable for three reasons.

The first reason was published in an IMF report in 2012, where a chief economist reported:

"When the crisis started in earnest in 2008, and aggregate demand collapsed, most central banks quickly decreased their policy rate to close to zero. Had they been able to, they would have decreased the rate further: estimates, based on a simple Taylor rule, suggest another 3 to 5 percent for the United States. But the zero nominal interest rate bound prevented them from doing so. One main implication was the need for more reliance on fiscal policy and for larger deficits than would have been the case absent the binding zero interest rate constraint.

It appears today that the world will likely avoid major deflation and thus avoid the deadly interaction of larger and larger deflation, higher and higher real interest rates, and a larger and larger output gap. But it is clear that the zero nominal interest rate bound has proven costly. 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."

To summarise this idea, if we had started with a higher inflation target, when the crisis came about in 2008, we would have had more room to manoeuvre our interest rate target in order to deal with the crisis. As it was, the zero nominal interest rate was reached quickly, and I believe I would be right in saying this lead to us being in a liquidity trap, where 0% interest rate isn't low enough.

The second reason for a higher inflation target would be greatly beneficial to European nations such as Spain, where their wages are very uncompetitive in comparison to Germany. If they were not in the Euro, they could simply devalue their currency, but as that is not an option, they must enforce nominal wage decreases, which are always going to be highly unpopular. As the Economist reported, "If inflation is humming along at 4%, however, then real wages can adjust downward more easily, simply by not keeping up with the price level. A higher inflation rate is therefore consistent with greater labour market flexibility and lower unemployment." 


Another advantage of higher inflation is that the real value of debt would decrease the higher the inflation. This would be both beneficial to the government in terms of dealing with their debt, and private households. If we had higher inflation, then households would be encouraged to take out loans and increase demand for products now, as the real value of their debt would decrease in the future.

These arguments are just some food for thought, and there are many counter-arguments!