Central banks falling short of 2 percent inflation target

By Josh Boak
AP Economics Writer

WASHINGTON (AP) — Is 2 percent inflation too high to reach?

The Federal Reserve and European Central Bank have been striving to generate a small dose of inflation — around 2 percent annually, just enough to spur more spending and income but not so much that prices surge out of control.

Both central banks are consistently failing.

And so the question has arisen of whether the Fed and the ECB should recognize that 2 percent inflation in a global economy awash in cheap oil, available workers and money-saving technologies might be too ambitious and should lower their targets.

ECB President Mario Draghi faced that very question at a news conference last Thursday in Frankfurt, Germany.

Draghi was having none of it, at least publicly.

He said that lowering the ECB’s 2 percent inflation target would represent an admission of failure that could damage the central bank’s authority.

“It will test our credibility if we were to change our target, when it’s taking more effort to achieve that target,” he said.

In the 19 European countries that share the euro currency, annual inflation is a scant 0.2 percent. In the United States, the Fed’s preferred inflation measure is 0.3 percent. U.S. inflation hasn’t breached 2 percent in more than three years.

The major central banks’ historically low interest rates and mass bond purchases have failed to offset the pressures of lower energy prices and tepid consumer demand.

When the Fed ends its next policy meeting on Sept. 17, it will announce whether it’s raising U.S. interest rates after nearly seven years of record lows. In calculating that decision, the Fed must weigh its confidence that inflation will return eventually to 2 percent — one of its mandates.

The credibility of the Fed and ECB hinges in part on their ability to achieve that level of inflation. And as that target remains distant, central bankers must maintain the extraordinary interventions they began with the 2008 global financial meltdown.

Lowering an inflation target would carry its own risks. For one thing, it would put countries perilously close to a deflationary trap. In this scenario, consumers would stop spending because goods and services keep becoming cheaper — which then stifles economic growth. That’s why economists and analysts say that central banks need to continue supporting economic growth.

Mohamed El-Erian, chief economic adviser at Allianz and a former deputy director of the International Monetary Fund, says the dilemma stems from an overreliance on interest-rate policies to support a floundering Europe. Alternatively, El-Erian argues, governments could have deployed other, budgetary options.

“The fundamental issue is neither the target nor what the ECB can do on its own to meet it,” he says. “It is about the lack of a comprehensive policy response that engages the full economic tools available to Europe.”

In the United States, the situation is somewhat different in the United States, where the unemployment rate is half the size of Europe’s. The U.S. jobless rate has dipped to 5.3 percent, a nearly normal level that would usually lead the Fed to raise rates. Yet low unemployment has failed to send inflation to the 2 percent target.

Some economists caution against a September rate hike by the Fed precisely because of the inflation target: They argue that a rate increase that takes effect before clear evidence of rising prices could choke off consumer and business spending and potentially income growth.

“When the world economy is fragile, you end up restraining demand,” says Stephen Oliner, a former Fed economist who is now a resident scholar at the American Enterprise Institute, a conservative think tank. “That’s why tightening now would be a head-scratcher.