Until price stability becomes the explicit, publicly recognized, and sole objective of monetary policy, a degree of inflation uncertainty is bound to persist. Let me now turn to the second of my three questions. In addition to expected inflation, inflation uncertainty increases nominal interest rates because lenders demand compensation for the risk that inflation might end up higher than they expected. The inflation risk premium, which effectively raises real borrowing costs, arises in policy regimes in which lenders judge that inflation will almost certainly not be less than expected, but could quite possibly be more than expected. Only a non-inflationary monetary regime can eradicate the inflation risk premium, thereby delivering the lowest sustainable real borrowing costs, which stimulate capital formation and lead to future growth.
International evidence suggests that investors often require substantial inflation risk premiums.
After they have been burned by inflation once, investors typically need years of solid inflation performance to convince them that the risk of inflation has subsided. For the past four years or so, almost all major industrial countries have had inflation rates well below 5 percent. Yet, the real borrowing costs on government securities differ widely across countries because of the substantial inflation risk premiums in those that have a long history of inflation. Borrowers persistently face higher real borrowing costs in these countries, even long after inflation has been brought down. Indeed, the prospect of reducing the inflation risk premium in their interest rates strongly motivates Italy, Portugal and Spain, for example, to join the European Monetary Union.