Winner of the New Statesman SPERI Prize in Political Economy 2016

Monday 2 July 2012

Prolonging unemployment to demonstrate inflation credibility

                Why do central banks in the US, UK and EZ appear to focus on inflation, and ignore unemployment or the output gap? More specifically, why are they apparently not prepared to allow inflation to be above target by, say, 1% for a few years in order to generate a more rapid recovery? There are many potential answers (see, for example, Joe Gagnon), but one that is often mentioned is that excess (above target) inflation would destroy anti-inflation credibility. Here is Bernanke in April (via Felix Salmon, HT Brad DeLong):

“We, the Federal Reserve, have spent 30 years building up credibility for low and stable inflation, which has proved extremely valuable in that we’ve been able to take strong accommodative actions in the last four or five years to support the economy without leading to an unanchoring of inflation expectations or a destabilization of inflation. To risk that asset for what I think would be quite tentative and perhaps doubtful gains on the real side would be, I think, an unwise thing to do.”

                What is exactly meant by this? In terms of a Phillips curve this statement seems odd. Over the last 4 years the recession has kept inflation and inflation expectations low. As long as unemployment remains above the natural rate, rising core inflation is not a danger. Is it plausible that QE might cause inflation without any impact on the real side?
The model that might make sense of such statements is the inflation bias literature. Those familiar with this can skip the next two paragraphs. This literature assumes that monetary policy makers are not content with unemployment at its natural rate. Although unemployment at this rate stabilises inflation, involuntary unemployment still exists at this rate because of market imperfections. As a result, with inflation and inflation expectations at target, policy makers will be tempted to raise inflation in order to reduce unemployment below the natural rate. For brevity, let’s call this the ‘overheating policy’.
                However, the private sector knows this when setting inflation expectations. If expectations are set at the inflation target, they will be too low, because policy makers will raise inflation to get lower unemployment. The only inflation guess that is rational (by which we mean that it will on average be correct) is an inflation level that is so high that policy makers are no longer tempted to pursue the overheating policy. We therefore get a rational expectations equilibrium where inflation is above target, but unemployment is at its natural rate. This excess inflation is called inflation bias.
                This idea was highly influential in persuading academics that independent central banks were a good idea. There are many versions of this argument, but one is that central bankers are less likely than politicians to be tempted to pursue the overheating policy (to reduce unemployment below the natural rate). However, ‘less likely’ is not the same as ‘never will’. So credibility in this context can simply mean the extent to which the private sector believes the monetary authority will not try the overheating policy.
                But what, you may ask, has this got to do with our current situation? Today unemployment is clearly above the natural rate. So a central bank that today traded a bit of excess inflation in order to get unemployment a bit closer to the natural rate need not be showing any signs of wanting to pursue overheating. They would simply be optimising the kind of social welfare function that macroeconomists assume all the time. There are no necessary implications for credibility as defined above.
                However, perhaps there is a more subtle point. Suppose there are two types of central bank: one that would like to try the overheating policy and one that would not. Credibility is about demonstrating that you are the second and not the first type. The private sector does not know which type the central bank is. In addition, the size of the output gap is uncertain, so evidence is messy. If the private sector is trying to guess which type its own central bank is, it might be more suspicious of a central bank that today raised inflation above target. As we noted above, this behaviour proves nothing, but it does not disprove anything either. However, a central bank that stuck with its inflation target even when unemployment is high is unlikely to also want to try the overheating policy, so this does prove something. Being indifferent to unemployment and strict on inflation demonstrates your credibility.
                If this is the argument, I have a suggestion. An even more effective way of establishing credibility, in my view, would be for monetary policymakers to agree to donate all their annual income to charity if inflation turned out to go above target at the same time that unemployment fell below the natural rate. (I am, of course, borrowing an idea from Carl Walsh.) Such a pledge would give a pretty clear indication that they would not intentionally pursue overheating.
                Now one might object that the members of the committee could turn out to be unlucky. We might get the combination of excess inflation and below natural rate unemployment because forecasts went wrong. So this is the potential cost of this proposal. But what is the certain cost of the current policy of using unemployment to demonstrate credibility? Happiness research (see, for example, the references here) suggests that something like the salary of a monetary policy maker is required to compensate just one unemployed person for the unhappiness caused by becoming unemployed. So if the policy of using unemployment to reinforce credibility reduces social welfare by the equivalent of[1] just 20 or more extra unemployed, it is more costly than my suggestion. In reality, the current policy stance is reducing social welfare by the equivalent of thousands of additional unemployed.
                You may think this suggestion is frivolous, and it is certainly unrealistic. But it is meant to illustrate an important point. Credibility should not be immune from a cost benefit analysis. Economists appreciate that few things have infinite worth, and credibility is not one of them.
                Nor do I think credibility is as fragile as central bankers appear to imagine. The idea that a central bank that allowed above target inflation in a situation of high unemployment would suddenly loose all the credibility they had established over the previous 30 years makes no sense.

[1] By the equivalent of, I mean after netting off the value of any consequent change in inflation. Happiness research also suggests (e.g. Di Tella, MacCulloch and Oswald, AER 2001) that, even if we ignore the unemployed themselves, a 1% fall in unemployment is worth at least as much as a 1% fall in inflation in terms of individual happiness. Add in the convexity we normally assume, and the current policy of (at best) hitting the inflation target but keeping unemployment high is clearly suboptimal. 


  1. I agree with much of the above post and given that US inflation expectations are on the low side of the target (and in the near term even below the target) the Fed's concern with credibility is a bit overblown.

    However, I think the author is forgetting that the whole point of Eggertson/Woodford price level targeting at the ZLB is to increase inflation expectations above the target in periods AFTER unemployment reaches its natural rate. Following SW-L's plan to commit to the target once we get out of the recession is actually more hawkish than Bernanke's current policy!

    The trick is to manage inflation expectations to be high over the medium term w/o losing long term credibility. But keep in mind that prominent voices (like IMF Chief economist Olivier Blanchard) advocate a switch to a long-term 4% target. Its very reasonable to think such a move would damage the credibility of a central bank, especially since its clear that one of the goals of such a move was to inflate away mounting central government debt.

  2. Being indifferent to unemployment and strict on inflation demonstrates your indifference to the plight of your citizens and your subservience to the interests of creditors and plutocrats.

  3. “Why do central banks . . . focus on inflation, and ignore unemployment or the output gap?” I think the explanations are more mundane / practical / political than Prof. Simon suggests.

    As to the UK, the idea that the Bank of England has not let inflation go above target is at variance with the facts: over the last two years it specifically said it was happy with above target inflation because it thought much of that inflation was cost push.

    As to the US, the Fed has done about as much as it can. It’s Congress that is blocking further stimulus.

    As to the EZ, the excessively deflationary policies there are due to the inherent defects of common currencies.

  4. Paolo Siciliani2 July 2012 at 09:30

    I raised the following point numerous times already. When private households are busy deleveraging and the labour market is slack current and expected higher inflation will push them to tighten their belts even further (in a Ricardian fashion), because they expect their disposable income to be squeezed since wages are not adjusting for inflation. This will hit aggregate demand and weaken the labour market further, thus unleashing a vicious cycle.

  5. But isn't it up to the elected politicians to define the "social welfare function" ? So, in the U.K. context, wouldn't it require the Treasury to change the Bank of England's mandate to allow the temporary inflation increase ?
    And would such a change be politically possible ? "The Government is taking reckless risks with inflation !" screams the Daily Mail......

  6. Current monetary policy would be sufficiently expansionary if it were accompanied by sane fiscal policy that would seek to alleviate short term unemployment. However, fiscal policy is dysfunctional at best and mean spirited at worst. Given that simulative fiscal policy is much more powerful than stimulative monetary policy at the zero lower bound, any attempts at additional stimulation by central bankers could easily be reversed and then some by even worse fiscal policy. Until fiscal policy can be brought on board to work in conjunction with monetary policy instead of opposing stimulatory monetary policy with contractionary fiscal policy monetary policy will not be as helpful as could be. Monetary policy, no matter how good cannot correct all the problems created by bad fiscal policy. The US and the Eurozone currently have BAD fiscal policy.

    jonny bakho

  7. One year ago the Swiss National Bank had a more urgent problem than inflation. The Swiss franc had just increased by 16% nearly overnight, and was now reaching parity with the euro, a 50% appreciation over the average rate that prevailed since the beginning of the euro.
    Admittedly, Switzerland has a positive trade balance, but such a rate would have proved destructive for entire areas of the Swiss economy.
    So the bank decided to set a threshold at CHF 1.20 for EUR 1, and it repeatedly confirmed that it would do "whatever it takes" for enforcing that threshold.
    This means that the SNB is ready to emit as many Swiss francs as necessary for buying euros, regardless of possible consequences on inflation. That's not supposed to be good for credibility, is it?

    Result: the threshold still holds and inflation is expected to be negative this year. As you say, credibility is not as fragile as some appear to imagine.

  8. For the eurozone the answer is simple: they have a single mandate by law: inflation.
    But what I wonder is if all this talk about making inflation 1% higher is actually feasible. Do central banks really have the power to control inflation to such extend that they can make it 1% lower or higher?
    And another topic of discussion is how inflation is measured. People around me laugh about the so called low inflation numbers. They experience higher fuel costs, higher energy costs, higher housing costs, higher healthcare costs, higher education costs for their kids, and often not just 5% higher but like 10-20% or more, and than they look at the news and watch the government claim that inflation was just 2%. How is this possible? I think a lot of people wouldn't mind a bit of deflation if that means costs go down.

  9. >file:///C:/docs/webpage/blogs/Prolonging%20unemployment%20to%20demonstrate%20inflation%20credibility%20is%20immoral.docx#_ftn1

    With people willing to invest in inflation-adjusted bonds with negative real interest rates, inflation won't cause people to "invest" in more business opportunities when lack of consumer demand is the limiting factor for many businesses.

    There is a strong argument that inflation increases spending, but only because it helps the financial markets at the expense of people's savings.

    Also see ... most economists like inflation, most other people don't.


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