The European Central Bank should raise its inflation target in order to boost the competitiveness of the euro zone economy, Nobel award winning economist Paul Krugman said today.
With inflation running considerably below the ECB's target of just under 2%, there has been considerable debate on what measures the ECB should take to ensure prices do not fall, but few calls to change the target.
"I am well aware that any proposal for a rise in the inflation target is greeted with extreme scepticism by central bankers," Krugman said at a forum on monetary policy organised by the ECB in Sintra, near the Portugese capital of Lisbon.
While officials are concerned a change in the target would damage their credibility, Krugman warned the world has changed and monetary policy needs to adapt.
"If the 2% target was defendable in the 1990s, it's likely not to be adequate in the future," said the Princeton University professor and New York Times columnist.
"There is a significant risk that Europe gets trapped in low inflation or deflation."
Deflation, or a sustained drop in prices, can be very damaging if consumers begin to postpone purchases in the hope prices will fall further, thus triggering a spiral of falling output, employment and prices.
However low inflation makes economic adjustment harder in euro zone countries that do not have the possibility to devalue their currency to regain competitiveness.
With moderate inflation economic competitiveness can be gained by freezing salaries, but when prices are nearly steady, outright cuts in wages are necessary.
ECB chief Mario Draghi said yesterday at the conference that the cental bank expects that low inflation will be prolonged but gradually return to close to the 2% target. He said the ECB was alert to risks that the current bout of low inflation, which has been regularly lower than expectations this year, might become self-reinforcing.
Expectations are high that the ECB will take some sort of action after Draghi said earlier this month the bank's governing council was "comfortable" with the idea of easing monetary conditions at the next policy meeting in June.
Raising the inflation target would also send a signal and change expectations.
"A relatively high inflation target can be regarded as a crucial form of insurance, a way of foreclosing the possibility of very bad outcomes," said Krugman.
Raising the target would be a non-starter with the Bundesbank, which has fiercely guarded against inflation as Germany still remains scarred by the memory of hyperinflation in the 1920s.