Present targets should ultimately give way to a stable price objective with ample scope for temporary deviations

Inflation in industrial countries last year averaged 1 to 2 per cent last year. So far from this low rate leading to depression, growth has been strong in the US and has been strengthening in Europe. There is a possible pick-up in Japan and there has been a recovery in the crisis-afflicted emerging market economies.

Yet every regular meeting of the European Central Bank, Federal Reserve Open Market committee or UK Monetary Policy Committee is awaited with trepidation. Lurking in the background is the fear that central banks may be overdoing the pursuit of low inflation. The International Monetary Fund has been sufficiently worried by this criticism to devote Chapter Four of its last World Economic Outlook to this question.

If inflation is a bad thing, can it ever be too low? The following are among the arguments most often used:-

1. Official measures of price inflation are biased upwards, for instance because they do not allow enough for quality improvements.
2. Wages are rigid downwards.
3. Inevitable variations around a low inflation rate will lead to some years of actual deflation.
4. Nominal interest rates cannot be less than zero. In the words of the Outlook this "places a floor under real interest rates that limits the extent to which monetary policy can support or stimulate aggregate demand."
5. In contrast, there is one highly abstract argument for a moderate rate of deflation. This is that paper money costs almost nothing to produce and if prices are merely stable people will hold a "sub-optimal" amount of it.

The fifth point is only mentioned because it turns up in economic discussions. Milton Friedman, who was one of its main discoverers, has never urged deflation in his policy proposals and has been more than happy to settle for broad stability in the value of money.

The first point about the upward bias of inflation measures is probably correct but not important enough to cause major policy errors. The IMF estimates average bias at less than 1 per cent. This is comfortably within official inflation target ranges lying between 1 and 3 per cent. The closest shave is Germany with an upward bias estimated in the range of 0.5 to 1.5 per cent compared with an ECB inflation target of 0 to 2 per cent.

The second point about wage rigidities receives enormous emphasis in the so- called literature. In a changing labour and product market there have to be changes in relative wages. These are more easily made if those at the losing end can get by with a smaller nominal pay increase rather than having to accept an absolute cut. The implication frequently drawn is that a literally stable price level is a bad objective and that policymakers should operate with modesty, but positive, inflation targets.

This conclusion is jumping the gun. The resistance to nominal pay cuts may itself be the product, as the IMF Outlook admits, of a period "when inflation has been around 3 per cent or above until very recently." Such behaviour may be a misleading guide to a world in which prices are as likely to fall as to rise. The annual wage run mentality could then eventually wither away and people could get used to the idea that modest wage changes in either direction are not the precursors of a savage squeeze.

If that occurred, the third worry about occasional deflation would matter less. The IMF Outlook rightly distinguishes between individual years of moderate deflation, which were frequent before World War One and a downward spiral of demand and activity which characterised the interwar depression. By contrast the fourth argument, about the floor under real interest rates - or liquidity trap as it is known to economists - needs all the emphasis it can get. Indeed during the oil shocks of the 1970s, world economic activity was cushioned by the fact that prices continued to rise. This allowed US real interest rates to drop to nearly minus 5 per cent, and in the UK lower still. It is quite likely that if all industrial countries had followed a policy of trying to offset the rise in oil prices by reductions in other prices straight away, the recession of that period would have been worse than it actually was.

The IMF view, based on US studies, is that an average nominal short- term interest rate of 3 per cent will provide sufficient downward flexibility for monetary policy to counter the types of recession we have had in the last few decades. This is well below the actual US levels in the last few years, but only just below French and German levels and well above Japanese ones.

If actually faced with a liquidity trap, governments will rely on not so brilliant improvisation. But the quality of that improvisation will depend on the background thinking which others have undertaken.

Several proposals exist.

One is to say that the harm induced by recessions is so large that we should be to have a substantial positive rate of inflation. This would allow real interest rates to swing around in negative as well as positive territory. This could make sense for a country such as Japan, which has been mired in recession for several years, but would be a counsel of despair for most countries most of the time.

There may, however, be a more specific course for Japan. According to Prof Ronald McKinnon of Stanford it is the belief that the medium term course of the yen will be upwards that causes Japanese business to have deflationary expectations and which makes monetary policy ineffective. His recipe is a currency stabilisation agreement between Japan and the US. One problem is to get the American side to accept this; another is to agree on the target; the third would be how to make it effective.

The conventional "Keynesian" solution is to use expansionary fiscal policy to overcome the liquidity trap. The IMF points out that this is inhibited not only by theoretical fears of offsetting variations in private savings and by "efficiency arguments for a stable, non- distortionary tax system", but also by the need of many countries to correct accumulated deficits and debt. In practice it will be best to rely on the operation of built-in-stabilisers under which government deficit automatically contracts in booms and rises in recessions.

A very different proposal, coming from the monetarist camp, is that central banks should in such circumstances not rely just on open market operations in a short-term government debt, but be prepared to extend their range of operations to long-term government securities, foreign exchange or even private securities. In other words monetary expansion does not have to rely simply on reductions in short-term nominal interest rates but can have a more direct effect on activity - if only central banks were more venturesome in this area.

The most radical proposal is still that made many years ago by the writer Silvio Gesell for currency with a negative interest rates. Notes would require periodic stamps to be put upon them and would gradually lose their value. Willem Buiter of the MPC has likened the Gesell proposal to a periodic currency reform on increasingly unfavourable terms. But he still thinks it might need to be taken seriously.

The main emphasis of the IMF Outlook is not on any of these proposals but on theme that if governments and central banks follow stable and responsible policies there would rarely be the type of recession which would need to be offset by negative real interest rates.

The temptation is to respond: tell that to the marines. To put it more politely: boom and bust are most unlikely to be banished even though good policies may help to moderate them.

My own conclusion would be not to split hairs arguing whether inflation targets should be 1, 2 or 2.5 per cent. I once nearly made a permanent enemy of Stanley Fischer, before he became Deputy Manager of the IMF, by suggesting a long term aim of price stability instead of a never-ending series of inflation targets. The idea was that people could make plans for their grandchildren on the assumption that prices would be equally likely to move in either direction. Of course any move towards zero inflation should be taken very gradually with plenty of time to look listen and learn.

The required short-term flexibility would be provided by accepting greater year to year fluctuations in the price level than are tolerated under present inflation target regimes.

With near stable prices achieved, central banks can make some more explicit recognition of the need to support growth, so long as this can be done without taking risks with inflation. This does not require a fundamental review of their terms of reference, nor a great debate on the relative merits of inflation targets versus nominal GDP. The latter can be brought in quietly and unobtrusively simply by putting more emphasis on the duty that most central banks have of supporting the economic policies of their governments, using all available techniques, so long as this can be done in a non-inflationary way.