Considerations in Reducing Inflation From Low to Lower Levels


WP/98/109-EAWP/98/109


Considerations in Reducing Inflation From Low to Lower Levels
Michael Leidy and Stephen Tokarick


In recent years, the rate of inflation in all of the major industrial
countries has moved to low levels, averaging just 2 percent in 1997. Despite a
degree of estimation bias in calculating inflation rates, these low rates are
not generally viewed as consistent with price stability. In the low-inflation
environment that now characterizes many industrial countries, should a policy
of further disinflation be pursued? This paper reviews the central
considerations in making that decision.


The evidence on possible growth effects of disinflation and the mitigation of
tax-based distortions is reviewed. Three channels are identified through which
a further reduction in inflation could impose economic costs. These are (i) the
employment/output effects resulting from downward nominal wage rigidities; (ii)
the impossibility of engineering negative real interest rates through monetary
policy under price stability; and (iii) the effect of further disinflation on
the real cost of servicing government debt. At very low rates of inflation, it
also becomes important to ask whether the objective of price stability and the
associated benefits can best be realized through targeting the rate of
inflation or the price level itself. The paper thus reviews the advantages and
disadvantages of price-level versus inflation targeting in a low-inflation
environment.


How the potential benefits might stack up against the costs of further
inflation reduction appear to depend principally on the extent and duration of
nominal wage rigidities in the economy. The superiority of a policy of
inflation versus price-level targeting hinges largely on whether a price-level
target will tend to induce greater macroeconomic instability. This issue
remains unsettled, but a price-level targeting regime, contrary to the dominant
view in the literature, need not produce increased output and employment
variability.