Is there a case for inflation targets? The UK versus the US.

One of my projects for the year ahead is to come off the fence (one way or another) on nominal GDP targeting. As an experiment, I’ll try and track my progress on this project with blog posts, although only if my thinking might be interesting to others. It is going to be a long process, because there is a lot involved: levels vs rates of change, GDP deflator vs CPI, nominal GDP versus its price component, and uncertainty about the natural rate to name some of the most obvious issues. However there is also another issue that may be just as important, and that is whether we need targets at all. In this post I just want to think about this last issue in relation to inflation targets, and not any other kind of target.

An obvious way for a macroeconomist to approach this is to imagine a world in which the central bank acts in society’s best interests, and has as good an idea as anyone else what those interests are. (The policy maker is benevolent, and knows the appropriate measure of social welfare to maximise.) Actually, for both the US and UK I do not think that is such a bad place to start. Let’s also suppose, as is standard, that society’s best interests involve getting inflation close to some desired level, and getting the output gap close to zero. Call this a dual mandate if you like. In such a world, why impose a target on the central bank? In other words, why do what is done in the UK rather than do what is done in the US?

By target, I mean something the central bank is required to try and hit. I am not talking about the central bank’s communication strategy. I take it as given that it is a good idea for the central bank without targets to be transparent about what its goals are, including what it thinks the desired inflation rate is. That is why this is effectively a comparison between the UK and US where in both cases transparency is fairly high.

The standard academic story involves time inconsistency and inflation bias. (Those familiar with this can skip the rest of this paragraph.) Essential to the inflation bias story is that a positive output gap (output above trend) is better for society than a zero output gap, for given levels of inflation. If you think this is obvious (more output is always better), remember more output means people working longer hours. If you think a zero output gap must be best, think about monopoly distortions or the impact of distortionary taxes. If a positive output gap is best, then a central bank may be tempted, once inflation expectations are formed, to try and temporarily raise output above the natural rate, knowing that the impact on inflation will be modest because inflation expectations are given. However rational agents will anticipate this, and the implication that their expectations about inflation will therefore be wrong. So they raise their inflation expectations above the central bank’s desired level, to a point at which the central bank no longer wants to raise inflation still further to get a positive output gap. The difference between this level of inflation and its desired level is inflation bias.

Although there is a huge literature on this, I have never been that persuaded of it’s continuing relevance in a world of long standing independent central banks. Central bankers, or academics on the UK’s Monetary Policy Committee, know that it is foolish to try and go for a positive output gap in this way, so they will avoid doing so. If the public nevertheless thought otherwise and therefore set inflation expectations above desired levels, the central bank would not settle for the inflation bias equilibrium (the time consistent or discretionary equilibrium), but would deflate the economy to get inflation down. This would soon convince the public that it was not trying to achieve a positive output gap.

Even if I’m right on this, we can still use the inflation bias argument in reverse. By this I mean that the public in ignorance will want the central bank to raise output above the natural rate, and the inflation target protects the central bank from this pressure. I mention this not because I think it is that convincing, but because this ‘using targets to protect the central bank from public pressure’ argument may have much more validity when we come to level targets. Of course the time inconsistency problem is more general than just inflation bias, but effects how the monetary authority responds to shocks (often called stabilisation bias), but here again levels targets may be more useful than inflation targets. 

I suspect the actual reason for inflation targets where they exist is more political. They increase the accountability of the central bank, and in some cases (like the UK) they allow politicians to set the target. These may be important advantages, particularly at the beginning of a new policy regime.

I also suspect that many macroeconomists have traditionally assumed (as I did) that the costs of inflation targeting were small, because if that target was achieved flexibly, it was quite compatible with optimising some combination of inflation and the output gap. The reason is of course the Phillips curve, which says inflation cannot be stable in the medium to long term if the output gap is non-zero. So a regime that targeted some fixed inflation target over the medium term would automatically achieve a zero output gap over the same time horizon.  Flexibility means leaving the choice of any particular short term combination of excess inflation and non-zero output gap up to the central bank.

This rather sanguine attitude has been tested by recent events. Some countries have experienced a whole series of positive inflationary ‘shocks’, some of which just reflect fiscal policy decisions. In the UK this has exhausted any flexibility that the MPC may have felt they had in not meeting the inflation target, so that their plans now involve meeting that target (or, indeed, expecting to slightly undershooting it), even though they forecast a large negative output gap to persist. Aiming to achieve the inflation target conflicts with what a benevolent policymaker would do. In contrast, the Fed in the US has (albeit only recently) explicitly countenanced exceeding their desired inflation level in an effort to get the output gap down. In other words, the inflation target in the UK is stopping the MPC doing what the Fed signal they are prepared to do.  

As a result, monetary policy in the US is better than in the UK, as a direct result of the impact of the inflation target in the UK. A related problem is the measure of inflation used. As I have pointed out before, the CPI is particularly susceptible to inflationary shocks like tax changes or higher commodity prices. As it is not obvious what the correct measure of inflation is from a welfare point of view, focusing on a measure that over a period is persistently higher than others may be distorting policy. The more this bias is hard wired in through mandated targets, the more sub-optimal policy may become.

So, my own view at the moment is that I prefer the flexible dual mandate approach in the US to the explicit inflation targeting regime in the UK.[1] Now of course this view is predicated on US monetary policymakers being fairly close to the benevolent ideal. If instead policymakers without a mandated target acted as if they all they cared about was CPI inflation (as in the ECB, for example), the disadvantages of an inflation target fall away. Nevertheless, what my view implies is that – all other things equal – the case for a nominal GDP target relative to the current regime is rather stronger in the UK than it is in the US right now. 

[1] A possible half way house has recently been suggested by Kate Barker, who was a member of the MPC, This would be to target a range (say 1%-3%), where the point chosen within that range by the MPC would depend on other factors, like the output gap.