Why the central bank should aim for a positive inflation target

The rate of inflation affects the relative prices of individual products and therefore the demand for those products. Using new micro price data, this column explores how high the optimal inflation rate should be to prevent relative product demand from being distorted. Contrary to a general claim, it shows that the optimum rate for a large part of the euro area is not zero, but in fact, in a clearly positive area.

With a few exceptions (such as the price of petrol), the prices of individual products are usually not consistently adjusted. As a result, when inflation is too high or too low, relative commodity prices become distorted. This long-established effect of inflation is strongly embedded in macroeconomic models. Relative prices are affected by inflation through at least two channels. First, inflation lowers the price of relative goods. As long as the price of a product remains unchanged, inflation – that is, the average price increase through the increase in the price of all other goods and services – means that the product related to other products becomes cheaper over time. Second, enterprises that reset their prices set them higher because they are expecting an inflation-induced price decline.

Distorted relative prices in turn affect the relative product demand, which means that the demand for specific products is then either too strong or not strong enough because the prices are not constantly adjusting. From a macroeconomic point of view, then, price distortion is the main source of the economic cost of inflation. In a new study (Adam et al. 2021), we estimate the rate of inflation that will minimize these costs for Germany, France and Italy.

Zero inflation as a reference point?

In many macroeconomic theory models, inflation reduces economic costs as a result of price distortions close to zero. This is because such models do not consider the relative strengths of the relative price trend over time as fundamental strengths. In part, this is why zero inflation has entered as an important reference point. However, once allowances are made for a relative price trend – for example, because products with increasing longevity can be produced more efficiently, which should be translated into price reduction – inflation can play a role in creating this desired relative price trend. Although commodity prices are rarely adjusted, the right level of inflation allows the price of a commodity to decrease in line with the potential effectiveness gain over a product’s lifetime. The question surrounding the optimal inflation rate then becomes a question of whether any relative price trend is actually justified by fundamental strengths such as production efficiency.

Relative price distortion On the one hand, of course, there are other arguments for optimal inflation rates other than zero – the opportunity cost to hold money, for example, or zero lower limit. Here, however, these arguments are ignored.

Our study is based on micro price data from official consumer price indices in Germany, France and Italy.1 The data was recently made available as part of EuroSystem’s Price-Setting Microdata Analysis Network (PRISMA) and includes more than 80 million price observations between 2010 and 2019. Depending on the country, data covers between 64% and 83% % Of the representative basket of consumer goods. Our empirical analysis uses these data to estimate relative price trends over a lifetime of products across different product segments. An earlier theoretical analysis (Adam and Weber, forthcoming) shows that, given reasonable assumptions, these assumptions can be interpreted as the preferred trend of relative prices. The theory further explains how estimating trends should be combined to set country-specific optimal inflation targets and how the macroeconomic costs of sub-optimal inflation can be calculated.

The optimal inflation rate varies across countries and commodities

Our empirical analysis for the baseline period 2015 (2016 for Italy) to 2019 shows that the optimal inflation rate is clearly positive for each of the three largest eurozone countries, reducing welfare costs associated with relative price distortion. Depending on the specific specifications of the empirical analysis, these rates are between 1.1% and 2.1% in France, 1.2% and 2.0% in Germany and 0.8% and 1.0% in Italy. The weighted average of the three countries produces an optimal inflation rate of between 1.1% and 1.7%. These clearly positive optimal inflation rates can be explained by the fact that relative prices should fall in all three countries due to fundamental strengths such as product production efficiency over a lifetime. Positive inflation then reduces the distortion of the relative prices that are generated because the price of the product is only adjusted irregularly. What this means, however, is that the reference point to zero inflation for these countries is empirically less powerful than previously thought.

Table 1 Estimates of the best inflation rate in the baseline period (% per year) and weight in the cost basket (%)

To better understand the differences between the countries, let’s examine the approximate optimal inflation rates for the broader product categories in the “food”, “non-energy industry products” and “services” table 1. Estimates for food are close to zero in all three countries. The same is true of services in France and Italy Estimated rates for services in Germany are actually negative, which means that German services become relatively more expensive for their lifetime. However, Table 1 also shows that a positive optimal inflation rate at the country level results in a strongly positive optimistic rate for industrial products. These rates are close to 5% for France and Germany but lower enough for Italy Thus, the overall overall inflation rate for Italy is lower than that of Germany or France. Inflation in the best products in Italy is very low because seasonal price declines in the fashion-driven product category “clothing and footwear” occur almost simultaneously on almost all products and therefore have little effect on relative prices.

A key question is how strongly the optimal inflation rate changes over time. Figure 1 shows a high correlation between the relative price trend between the baseline period and the previous period. This suggests that, even for the fine-tuned product segment, the optimal rate is surprisingly stable over time. The best inflation rate for the baseline period therefore can also serve as a good indicator of the optimal inflation rate after the epidemic.

Figure 1 Annual Relative Price Decrease (%) in Isolated Expenditure Section

Estimation of optimal inflation rate which reduces the welfare expenditure related to price distortion and allows to come to a conclusion regarding the expenditure of different inflation situations. If inflation returns to the same moderate level after the epidemic in the 2015-19 period, the estimated cost will be lower, as the inflation rate in each country was close to the optimum rate during this period. If inflation stays at zero for long periods of time – that is, the reference value is considered optimal in many theoretical models – the average welfare expenditure across the country under review coincides with a 5% reduction in current lifetime value if the cost inflation rate continues for long. The estimated cost will still be high enough.

Conclusion

The availability of detailed micro price data allows for further refinement of existing theories of optimal inflation rates. While the economic reasons for the relative depreciation of commodities over a lifetime are taken into account, the rate of inflation that reduces the distortion of relative prices is clearly positive and is between 1.1% and 1.7% in the three largest eurozone countries. The previous reference point to zero inflation would therefore seem to be empirically less powerful for these countries than previously estimated. The best inflation rate estimates contributed to the further development of the ECB’s monetary policy strategy last year and are likely to continue in the future.

Author’s note: The views expressed here do not reflect those of Deutsche Bundesbank, Bank de France, or the Eurosystem.

References

Adam, K. and H. Weber (forthcoming), “Estimating the Best Inflation Target from Relative Price Trends”, American Economic Journal: Macroeconomics.

Adam, K, E Gautier, S Santoro and H Weber (2021), “Positive Eurozone Inflation Targets: Evidence from France, Germany and Italy”, CEPR Debate 16828.

Endnote

1 French micro-pricing information is provided by the Institut National de statistique et des études économiques (Insee) through the Center d’accès sécurisé distant aux données (CASD). Research Statistics of the Federal Statistical Office (Destatis) and the Federal Statistical Office (“Einzeldaten des Verbraucherpreisindex 2018”, EVAS No. 61111, 2010-2019, 2010-2019, 2011 / DOI .00.00.1.1.0 to 10.21242 / 61111.20. 1.1.0). Small price data for Italy was provided by Istituto nazionale di statistica (ISTAT).

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