Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday 26 February 2012

Going beyond Quantitative Easing

                I’ve been away for a few days at the OECD, so have only just picked up Scott Sumner, fully endorsed by Tyler Cowen, asking why there are not more people advocating a higher inflation target, or a nominal GDP target, in the UK. (Being away did not in theory prevent me blogging, but I’m afraid in practice I prefer exploring Paris!) I think this is a good question. While there is a very active UK debate about fiscal austerity, most discussion on the monetary side tends to be within the parameters of current policy.  
                Those familiar with the case for raising the inflation target can skip the next couple of paragraphs. For those who are not, the idea is that the central bank/government could moderate the impact of the zero lower bound constraint on interest rates by announcing that it would allow inflation to go above 2% for a significant period after the recession was over. This would help stimulate the economy today through various channels. One is that expected lower future short interest rates should reduce long term interest rates today, which would in turn stimulate borrowing by firms and consumers. Another is that, according to the New Keynesian Phillips curve, expected inflation today depends on expected inflation tomorrow, so if the central bank allowed above 2% inflation in the future, this would raise actual and expected inflation today, lowering real short term interest rates today. One of the interesting things about this policy proposal is that it is very New Keynesian rather than Old Keynesian.
                This policy was first suggested as a way out of Japan’s lost decade (when nominal rates were also stuck at the zero bound) by Paul Krugman, and subsequently formalised by Eggertsson and Woodford (Gauti B. Eggertsson & Michael Woodford, 2003. "Optimal Monetary Policy in a Liquidity Trap," NBER Working Papers 9968) among others. This paper suggests that the optimal policy can be approximated by replacing an inflation target with a price level target, because a price level target implies a period of excess inflation would automatically follow a period of insufficient inflation. Scott Sumner in particular has championed nominal GDP targeting, which would have similar effects, and this policy has gained a lot of support in the US and elsewhere.
                So why relatively little debate on this issue in the UK? At the political level, simple politics combined with recent experience may be important. Price inflation has been, and still is, high in the UK, and this is highly unpopular because it has been associated with large falls in real wages. An argument by any political party that the Bank should target higher inflation, rather than be admonished for its inability to prevent it, would be a hard sell. Nominal GDP (NGDP) targeting may be much more palatable to a non-macro audience, as Krugman points out. However a problem here for the government may be the accusation that such a change reflects a failure of their austerity programme, for reasons discussed below. Whether this issue might be on the Labour Party’s agenda I have no idea, although I cannot see any reason in principle why it should not be.
                What is perhaps more puzzling is a lack of discussion by the Bank itself. As far as I am aware, the Bank has not discussed these various alternatives to its current 2% mandate. I am also not aware of any members of the current MPC discussing them in public. Of course any decision to change the mandate would not be for the Bank or MPC to make – it’s a decision for the Chancellor - but that does not rule out discussion of options. I think this lack of ‘official’ discussion may also discourage debate elsewhere. (I know I thought of writing something myself on this a few weeks back, looked for something from the Bank as a ‘hook’ to argue with, and on finding nothing let it slide.) In contrast to the US, macroeconomic blogs in the UK are not developed or influential enough to initiate a debate themselves.
                The lack of public analysis from the Bank, or MPC members, could perhaps be another example of ‘groupthink’ that Laurence Ball suggests in his analysis of Bernanke’s views on the zero lower bound. My first experience of this came at a conference organised by the Centre for Central Banking Studies in 2009. Chris Sims and Mike Woodford were the other guest speakers, and both my and Mike’s paper provoked discussion of this policy issue. I have often been in meetings where an option may be politely discussed, but you just know it has no chance of serious consideration, and this seemed like one of those. To be honest, I think this represents central bank conservatism more than anything else.
                One of the main arguments against this policy option is time inconsistency. Even if a promise to raise future inflation was effective today, when the recession ended and it was time to implement the policy, the temptation would be to renege on this commitment and return to the 2% inflation target. A smart private sector would realise this, so the promise to raise future inflation would not be believed, and so it would not be effective. A price level or NGDP target is partly designed to help overcome this problem. However, in the case of the UK, where a change in policy would almost certainly have to be decided by the Chancellor rather than the Bank, this should be seen as less of a problem for the Bank or MPC. Its credibility would not be on the line, and the government rather than the Bank would come under pressure to renege.
                Exactly the same could be said of another objection to raising the inflation target, which is that it might be perceived as a way of helping the government reduce the ratio of debt to GDP. This charge could be a more serious concern for the Chancellor, if it was perceived that his austerity program was not delivering the fiscal target he had set himself. However, it should be less of a concern for the Bank, because they have always deferred to the Chancellor’s authority to set the inflation target. So for both reasons, I suspect the lack of discussion by the Bank and MPC may reflect a taboo about deliberately raising inflation above 2%.
                I should add that I think the advocates of NGDP targets sometimes go too far in suggesting that this is an obviously preferable way to speed economic recovery compared to fiscal stimulus. Promises to raise future inflation are costly, which is why there is a time inconsistency problem. However the current recession is, in my view, much more costly, so it needs both monetary and fiscal action to help bring it to a speedy end. Furthermore, the current recession may well indicate an endemic problem with low inflation targets, which is that we are in danger of hitting the zero bound quite frequently. (With this in mind, can anyone explain to me why the Bank of Japan has just announced an inflation target of only 1%?) This seems like an excellent time to be discussing alternatives to inflation targeting. 
So it is a pity that this policy option is not being debated more actively in the UK right now, with help from the Bank and MPC members. In the absence of a discussion based around the Bank, then this seems to be exactly the kind of issue that the Treasury Select Committee of the House of Commons should investigate. The committee has always taken a keen interest in all aspects of monetary policy, and such an investigation would be a good follow-up to their recent report on Bank accountability


  1. Bearing in mind the cyclical recovery of prices after a depression, it would not be very difficult to create a reasonable inflationary gap even if the initial target for inflation it set not too high above the 2%.

    Government could offset any criticism by distributing back into the community the proceeds from the inflation tax in the form of tax cuts for low income earners, which could even be made to coincide with next election.

    The problem is, as Keynes said: In a commodity inflation the earnings of the factors of production are worth less than what they are producing and the difference is arbitrarily distributed amongst the members of the entrepreneurial class" but that would be not too much to pay in order to reduce unemployment.

  2. I quite like the idea of a price-level target, but the fact that we are in a period of excessive inflation would seem to imply that under such a regime monetary policy would need to be tightened, reducing expectations of future inflation.

    As for changing the inflation target, I think this is a dangerous game. It would undermine the credibility of the inflation target because people would infer that the inflation target would be raised whenever it was expedient to do so. Note that there would never be a reason to reduce the target. So we end up with an inflation bias because we've added an element of discretion to monetary policy. Long-term inflation expectations would no longer be anchored to the present inflation target.

    As for the question:

    "can anyone explain to me why the Bank of Japan has just announced an inflation target of only 1%?"

    perhaps it's because they have a hard time achieving a higher inflation rate. If they target 3% but only achieve 1%, people will lose faith in the target.

  3. Given the levels of inflation in the UK over the last few years, we had sort of assumed that NGDP targetting had already become discreetly accepted policy at the BoE. Shame it hasn't actually started working yet.

  4. The UK government is busy at the moment. We've got ourselves into a bit of a mess with Murdoch, McKinsey, privatising the NHS and so on. Little things like the economy will have to wait; our careers are at stake here.

  5. I agree with Geoff Willis above: the BoE is effectively already doing NGDP targeting. At least it certainly is not doing pure inflation targeting.

    As to the arguments against a more powerful monetary stimulus without any assistance from fiscal, I set out above ten reasons against such a policy here:

    As to a more powerful monetary stimulus deriving from higher inflation I can think of a very good argument against this: if the only way of getting monetary policy to do more involves debasing the currency and robbing pensioners of their savings, then trying to get monetary policy to do more without any assistance from fiscal is a farce, to put it politely.

    Also, it would be perfectly possible to get monetary policy alone to do more WITHOUT deliberately stoking inflation (at least on some definitions of the words monetary and fiscal). We could just print money and distribute it to households via reduced VAT, reduced National Insurance contributions, etc.

    1. "Also, it would be perfectly possible to get monetary policy alone to do more WITHOUT deliberately stoking inflation (at least on some definitions of the words monetary and fiscal). We could just print money and distribute it to households via reduced VAT, reduced National Insurance contributions, etc."

      You don't think this would lead to inflation?


Unfortunately because of spam with embedded links (which then flag up warnings about the whole site on some browsers), I have to personally moderate all comments. As a result, your comment may not appear for some time. In addition, I cannot publish comments with links to websites because it takes too much time to check whether these sites are legitimate.