By contrast, the credibility associated with pursuing only an inflation target builds on itself. Given this, it would be safer and more effective for the Fed and other central banks to pursue a single inflation target, and then use the gain in credibility to aid economic recovery.
For example, a central bank might announce that circumstances during, say, the next two years warrant a doubling of the inflation target from the usual — that is, almost never varied — annual rate of 2 percent. Such an approach would reduce the risk of debt deflation, while capping inflation expectations to prevent a damaging surge in prices as recovery takes hold.
Such preventive measures are all the more important in view of the Great Inflation’s second relevant lesson: fiscal discipline is essential to price stability. Sustaining a high budget deficit over many years will lead to an unmanageable debt buildup, unless that debt is inflated away or restructured.
As it stands, the US — and presumably the UK — plans to begin tapering QE when the economy is growing faster, unemployment is lower, and government and household revenues are rising. However, will tax revenues rise fast enough to offset the escalating cost of servicing the government’s mountain of debt?
Even if public debt is not growing as fast as before, the huge volume of existing debt must be repaid. The best cure would be controlled higher inflation — that is, the aforementioned temporary increase in the inflation target — to erode the real value of public debt and forestall the risk of a much more damaging inflationary shock later, one in which expectations become unhinged.
However, while this approach could work in the US, the European Central Bank (ECB) is institutionally constrained from raising the inflation target. Although its pledge in August last year to purchase unlimited quantities of short-term government debt has calmed markets, activation of the ECB’s “outright monetary transactions” program is conditional on continued fiscal retrenchment. So the eurozone’s crisis-stricken economies cannot grow.
In this context, the eurozone’s most heavily indebted countries will have to force their creditors to accept a restructuring of public debt. The preferable alternative would be growth-boosting devaluations — that is, a eurozone breakup. However, if, as seems likely, such devaluations are left too late, debt restructuring might still be needed.
In the coming years, Europe appears set to lurch from the frying pan of depression to the fire of high inflation. When it does, the lessons of the Great Inflation will suddenly be all too pertinent.
Brigitte Granville is a professor of international economics and economic policy at the School of Business and Management, Queen Mary, University of London.