Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday 2 December 2012

How to try and get more inflation quickly

The following is written in the UK context, but the proposal I make would work in the US and the Eurozone as well.

Wednesday will be Autumn Statement day in the UK: one of the two times a year the Chancellor makes big fiscal announcements. Yet this post will not be about fiscal policy: current policy looks too much like rearranging the deck chairs, and so I will just be repeating myself in saying that the strategy is all wrong. Instead this post is about monetary policy. How come - that is the MPC at the Bank of England surely? I think not - they are just rearranging the deck chairs too. The big picture on UK monetary policy is down to the Chancellor.

The MPC’s mandate, set by the Chancellor, is to hit 2% for CPI inflation ‘within a reasonable time period’. In the past I and others thought the phrase reasonable time period would allow the MPC in practice to minimise a combination of excess inflation and the output gap, which is what most macroeconomists assume monetary policy is all about. I think this was true, within limits. In the UK these limits were surpassed following the Great Recession, where we had a large negative output gap but above target inflation. We are at the ZLB, and have had Quantitative Easing (QE), because the MPC looked at the output gap as well as inflation, and thought that a large output gap would mean inflation would come tumbling down. It did not, so now they are just targeting CPI inflation (and rather conservatively at that).

What we need is for UK monetary policy to be as expansionary as it can be, and we are not going to get that under the current system, even with a new man running the Bank. I have talked to enough MPC members to know that they take the mandate they are given very seriously. They certainly believe they do not have the discretion to follow a different strategy while still paying lip service to the current set up. The system can only be changed by the Chancellor. Now some would like him to move to nominal GDP targets, and I’d be happy with that. However I cannot see him doing that overnight: the move to include output and go from changes to levels is probably too much for something that is not widely discussed in the UK . The best we can hope for (and hope is the word) is for him to launch some kind of inquiry into this (and other) possibilities - I have suggested in the past that the Treasury Select Committee could do this.

So for the next year or two we are almost certainly stuck with inflation targeting. He could announce an increase in the inflation target, which he has the discretion to do as part of the current system. But he will not, because it plays terribly in terms of politics. As Noah Smith laments, what we as economists understand as inflation is not what everyone else understands by inflation. The number of people in the UK who would be prepared to defend raising the current CPI inflation target to 4% (which I would) is probably less than the number of economics departments in the UK.

However, why not change the measure of inflation being targeted? The GDP deflator is the obvious alternative, but there is a better candidate if the aim is produce a significant but temporary rise UK inflation (and thereby to start a proper recovery in UK output). My suggestion is that 2% CPI inflation is replaced by a target for 4% growth in average earnings. In normal times 4% earnings growth and 2% CPI inflation would be quite compatible (because real wages grow with productivity), but currently average weekly earnings inflation is below 2%.[1] So moving wage inflation from 2% to 4% is a real challenge for monetary policy. To help with this challenge, the Chancellor could at the same time sanction unlimited QE, and could suggest this goes beyond just buying gilts.

If monetary policy still has some power despite the ZLB, then this move would have a significant effect in reducing real interest rates. It would also play well politically. “In the last few years hard working families have seen the real value of their earnings fall, as wage growth has been held back while the Bank of England has failed to keep consumer price inflation on target. It is time that we changed things so that the rewards from working increased rather than decreased over time. That is why I am announcing today ….” Rhetoric that is nonsense in terms of economics, but no worse than much of the rhetoric the government currently uses.

Now of course plenty of people will complain that this is returning us to the 1970s, losing all the gains in inflation credibility that we have carefully built up etc etc. But their arguments can be easily countered. If CPI inflation does rise, this helps get round the ZLB, and so should stimulate a recovery. Yet it cannot ‘open the floodgates’, because all that has happened is that the definition of the inflation target has been changed. There is no further change in definition that can lead to yet higher inflation. In the longer term 4% wage inflation is pretty compatible with 2% price inflation, unless you believe that UK productivity growth can never grow again at levels that were thought normal before the recession. Finally I do not think there is anything in the academic literature which says that the CPI index is a significantly better measure to target than an earnings index.

In an ideal world, would I be suggesting this change? Almost certainly not. Do I think it is better than nominal GDP targeting? Probably not. However, we are not in an ideal world, and we need some action right now. Otherwise there is a great danger that we continue down a road of self-fulfilling pessimism, with all the misery and loss of resources that this entails. 

[1] That wage inflation is currently well behind price inflation plus underlying productivity growth is not just a UK phenomenon - it applies in the US and Eurozone as well. To that extent this proposal is not just of relevance to the UK, although elsewhere central banks have the power to make this change, whereas in the UK they do not.


  1. Do I think it is better than nominal GDP targeting? Probably not.

    Interestingly, you disagree with Scott Sumner here, who declared wage targeting his actual preferred policy...

  2. The BoE targets inflation? It’s been described as a closet NGDP targeter. And that description is valid in that over the last three years or so it deliberately didn’t clamp down on inflation because it thought much of that inflation was cost push.

  3. Like To, I am curious about why you think nominal wage targeting would be worse than NGDP targeting?

    Personally, I worry that if you explicitly stated a 4% wage target, then 4% would become the new zero for downwards nominal rigidity, so you could hit the target and still have a depressed economy.

    Politically, I think it would be a bigger change than NGDP targeting, after all you could make the same argument that X% NGDP growth is compatible with 2% inflation in normal times. Level/rate targeting is an issue both ways.

  4. Shouldnot you first ask yourself the question should we do anything at all?
    The mindset with which you attack this issue is very similar to the one of the decisionmakers that created a lot of the mess we are now in. Basically by not allowing things to rebalance.
    Mere mortals mingling in markets they only partly understand.

    1. If I may say so, this is nonsense. The financial crisis was created by markets, not policymakers - we needed more intervention. The job of monetary policy is to balance aggregate supply and demand - it does not happen by itself.

  5. Public support for an independent BoE could be quickly eroded if they started targetting wage inflation. Saying that interest rates are going up because prices are going up too fast may be quite different in the public mind than interest rates are going up because wages are going up too fast.

    Also, this doesn't allow for the fact that underlying productivity growth might change quite a lot. Unlike prices, wages contain a real as well as a nominal component, and so a trend change in the real component would mean that we would have to tolerate a trend change in the growth rate of the nominal component (an argument along these lines can also be used with respect to NGDP targeting..).

    1. But if productivity growth does vary, is it better to have stable price inflation or stable wage inflation?

  6. Would you disregard inflation completely ? Would a combination of nominal 4% wage growth and 5 or 6% CPI growth be (at least temporarily) acceptable ?

    1. In the current context, yes. In the longer term there is no correct index to target, which is why its difficult, and why I'm suggesting this as a temporary measure while a more permanent change is considered.

  7. Good post. But I think you should stick to your first-best NGDPLPT guns. Rather than write a very long comment explaining why, I wrote a post instead.

    1. Nick - I think in the context of my post your post actually suggests the opposite! You suggest that an inflation target may be more likely than a NGDP target to encourage firms to coordinate their price setting. I think that would be great, because it is through higher expected inflation that I see higher demand, and therefore output, coming about. In your post you seem to do things the other way around: you assume the additional NGDP, and ask about how it is divided up.

    2. Simon: but higher expected real growth, as well as higher expected inflation, would also cause higher demand. (E.g. the Et(Yt+1) term in the New Keynesian IS curve). So both would give us higher demand, but if they coordinate on real growth rather than raising prices, that would be a better outcome.

    3. Nick: Maybe I can put it this way. Under current policy we could get 1% real growth and 2% nominal, so NGDP increases by 3%. Lets suppose the Bank hits whatever it targets. The likely NGDP target would be 5%, which might be split 2% real and 3% nominal. I want a nominal target of 4%, which because it reduces real interest rates further could get us even more real growth i.e. 3%. So I would hope for 7% NGDP growth. Now you might say why not have a 7% NGDP target. But that will not happen for the same political reason that the current nominal target will not be raised. The 4% wage growth target is just a way of getting round that political constraint, in the particular circumstances we happen to be in. That is why I said the 4% wage growth target was a temporary measure, leaving the way open for NGDP targets as a longer term alternative.

  8. Your point is that inflation targeting currently leads to excessively tight monetary policy. I agree, but I do not think that nominal wage growth targeting makes a lot of difference in that respect.

    I would rather suggest to state monetary policy in terms of achieving stable long-term nominal bond yields, say 4% to 5%. The idea is that, if the natural level of real interest rates needs to be negative, then the central bank would be forced to pursue strongly inflationary policies.

    I find the following quite striking. When the Fed announced its last QE operation, inflation expectations rose, but long-term bond yields barely budged. Is that not an indication that real interest rates were too high in the first place? In Japan, 5-year inflation expectations have been going up from -2% to about +0.8% over the last 2 years, while 5-year nominal bond yields have come down from 1.5% to 0.8% over the same period. Again, is that not an indication that real interest rates were way off equilibrium at the start of the process?

  9. I've never understood the credibility danger of announcing and executing a temporary increase in the inflation target.

    If the Fed said "we're going to let (wage) inflation float a bit until the economy's back up near capacity, then bring it back down," and then did exactly that, wouldn't that greatly *enhance* their reputation for being able to control inflation?

    1. I think the credibility argument is really about the underlying motives of the policymakers, rather than their abilities. However I also think that argument is overdone - it takes a few generations to forget the lessons of the past, and policymakers are still obsessed with the 1970s. My argument for why the Chancellor would not announce a higher inflation target was political, and here the UK context is different from the US and Eurozone, because central bankers are less subject to these political pressures.

    2. You touch on both my explanations for the credibility argument:

      1. It's a smokescreen. Actual reason: Creditors *hate* (unexpected) inflation. One extra point transfers *hundreds of billions of dollars* of buying power from creditors to debtors, annually. 'Nuf to get a fellow's attention. The Fed is run by creditors.

      2. (70s) They actually *are* worried -- that they'll run into a stagflation situation where stomping on inflation is...problematic. So they won't be able to fulfill the second half of their promise without causing a job recession a la Volcker.

  10. Well there was intervention (like keeping interest down), only clearly not the right kind I agree with that.
    If you give markets (and consumers/houseowners), as we see now again, extremely cheap credit they buy things with it and you create bubbles (or better run the chance you do and pre-crisis it clearly was that way).
    The problem with bubbles being that the hot air has to come out at some time. RE basically via inflation (probably the least bad option) but that is hardly great as it makes investing in it very unlucrative for a decade or more from now. And basically substantially limits your room to substantially increase interest, if that would be necessary (eg to tackle inflationfears from all those printing-like activities) as half your homeowners would go bust.
    Markets created the bubbles but policymakers (both fiscal and monetary) were pretty helpful in creating the conditions in which that could happen.

    My first point is that doing nothing is simply not seen as an option. While it could be the best thing to do, but we never come that question as it is simply not on the table as an alternative. CBs apparently have to look being active, whether it works or not. At least that looks the way they think.

    My other point is that if apparently was not possible to properly manage the bubble situation. A pretty simple one. Why take the bet on something that is/looks considerably more complicated? Management capacity (not numbers but qualitywise) looked completely stretched already with the RE bubble (and a few other things). If there is one thing I learned never let somebody do something that looks way over his (I not add her as women as you know never make mistakes) head if that thing is really important.

    It is basically more a management issue than a pure economic one, but a management issue that is essential for making it (your theoretical economical idea) work in real life.

  11. Nice post!

    It took little more than a month for HM Treasury to switch from exchange-rate targeting to inflation-targeting in 1992 - I believe they can still execute a radical about-turn when necessary.

    Recent rumours in the press indicate both that HM Treasury has shown some interest in NGDP targeting, and that they are dissatisfied with the current BoE - why else appoint Mark Carney? Vince Cable has also spoken on record very clearly in favour of NGDP targeting, so I'm confident half of the Coalition would be on board.

    Given the above, if there is to be a major shift in UK macro policy, NGDP level targeting does not seem like an impossible leap to me, and definitely worth rooting for.

  12. Brief the unions in advance what the target is going to be, and that they can let her rip.

  13. If the B of E really had a 2% inflation target, shouldn't they stick to it occasionally? They just have a 2% inflation expectation to try keep under control. I think you will find the two things are vastly different. Have you never checked to see how many times they have not achieved the "target".

    As someone reliant on the income from savings and obviously not doing well now with what used to be my interest income, being stolen and given to debtors and bankers, what do you think your plan of wage inflation would do for people like me? In their 50's, little chance of work now but I put hard earned money aside for years, to build a cushion that has now been ripped out from under me? Would it be quicker if I just burnt it for you?

  14. Simon: Do you think your proposal would result in wage inflation being higher relative to CPI?

    I surmise from your "Rhetoric that is nonsense in terms of economics" that you would answer "No" -- that equilibriating processes would result in the same outcome as if (core) CPI were targeted.

    I understand that position (if I've characterized it right), but I really have to wonder. It seems like wage inflation (threatening the dreaded wage-price spiral) has been a big bogeyman that the Fed has used for decades as a signal of "need to tighten."

    Do you think a publicly stated target countering that tendency would tend to have an effect in keeping with the rhetoric's stated intent?

  15. Have a look at recent research from UBS (Deo if I am correct) on shares as a hedge for inflation.
    It basically states that after 4% relative shareprices (pretty equal to business confidence) go down. So that looks to be (almost) the max.
    Furthermore markets look as I see it more to inflation in that respect than wages so looks safer to target inflation directly if that is what you want.
    Effectively King already did more or less the max he could do if you take the 4% guideline.
    Of course assumptions are a bit different now: QE means more liquidity in the market so higher prices. On the other side fear for a fat tail (very high inflation) will most likely work in the other direction.


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