The central banks' inability to achieve their inflation targets led some analysts to argue for modifying these targets. Are they inappropriate in a modern, globalized economy? Should central banks change them? Or should they conduct a more rule-based policy, as John Taylor argues? How would such moves affect the gold market?
As a reminder, the Fed (as well as other major central banks) targets 2-percent inflation. It may seem to be strange, as such a level is far away from the price stability (which, taken literally, means neither inflation nor deflation), which the central banks should are obliged to ensure. However, deflation is a central banks' worst nightmare, so they want to have some buffer in case of negative demand shock. With the inflation target at zero, the margin of error would be very limited. But central banks have been missing their targets for years – should they change them?
In the October 2016 edition of the Market Overview, we discussed the idea of raising inflation targets. It would push the zero-bound problem away and increase central banks' room for action. But how would the central banks achieve, let's say,4-percent inflation, if they cannot generate the mere 2-percent rise in prices?
So should central banks perhaps lower inflation targets, confirming their inability to meet the 2-percent targets in the modern, global economy? It is a tempting vision, as lower inflation targets would imply faster normalization of monetary policy. But there are some problems with that as well. First of all, lower inflation targets would decrease the interest rates (due to softer inflation premium demanded by investors), limiting the room to maneuver of central banks and exacerbating the zero-bound constraint even further.
Moreover, modifying parameters for ad-hoc needs could reduce central banks' credibility and the confidence in the whole financial sector, as interest rates that are too low hinder financial intermediation (banks are less willing to lend money). It could spur some safe-haven demand for gold, but lowering the inflation target could actually strengthen investors' faith in central banks (it would be easier for them to achieve lower targets), hurting gold bulls. And lower inflation rate corresponds to higher real interest rates, which could be bearish for the gold market.
