Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday 6 August 2013

Is it possible to raise the inflation target?

This post is not about whether raising the inflation target is a good idea or not. Instead I want you to imagine that, after much analysis, a clear majority of the macroeconomics profession decided that it was a good idea. This post is about imperfections in representative democracy and what policy design can do about it, so I need you to go along with me in this thought experiment. You should be able to, for whatever your views on the optimal inflation target, you must be able to imagine the possibility that - for example - the frequency of ZLB episodes and their costs meant that a higher inflation target became optimal. [1]

Like many economics seminars these days, before I get a chance to talk about this you could raise another objection. Has Japan not shown that it is possible to raise the inflation target? Of course it has, but think about the circumstances. Japan moved from a high growth economy to near stagnation in 1990. It has taken nearly 25 years for the political process to realise that maybe this might have something to do with having a monetary policy that seemed content with zero inflation. As Paul Krugman would be the first to remind you, it is not as if no one told them what the problem might be. So it seems to me Japan shows why my question is a very good one: despite what would appear to be a macroeconomic disaster, it took two decades before the political process tried a fairly obvious remedy (moving the inflation target to the same level as the US and UK!). [2]

So what are the barriers here? Why would politicians not just say: ‘economists are the experts, and if that is what the clear majority recommend, so be it’. I can think of two reasons why this would not happen. The first is that this policy, like most macroeconomic policies, would not be a Pareto improvement: even if the majority gain, some would lose. If - and this is an important if - those who lose out have political power, then they would contest this ‘recommendation by experts’. [3] The second is that public debate operates a discourse on macroeconomics that does not necessarily reflect how macroeconomists view the world, and which also contains some fairly basic misunderstandings. In this discourse, inflation is always and everywhere a ‘bad thing’, because it means people can buy less with their money. Many people think inflation by definition means falling real wages (see this study by Robert Shiller for example). [4]

Now we could argue about which is the more important of these two factors, but I think it is the combination that is critical. Simple misconceptions could be overcome by politicians if their attempts to do so were uncontested. Equally, the political process is all about a contest between different groups in society, so if this were all there was then at least we should see a debate, as long as each side had its advocates. However, putting the two factors together can kill debate. We get argument by ridicule: ‘How can anyone seriously suggest raising inflation is a good idea, when everyone knows it makes us all worse off.’ A retort that most macroeconomists think it is a good idea just does not cut it in these circumstances, for reasons I have discussed before. As a result, even politicians who might favour the idea conclude that it is far too risky to champion.

These thoughts occurred to me when I was writing about the monetary policy regime set up by the UK Labour government in 1997. As I listed some of its virtues, I remembered that I have previously included in that list having the finance minister set the inflation target. This time I did not, and this post explains why.

Inflation targets are not the only macroeconomic example of where this problem arises. Government borrowing has, at least in the UK, become something that is perceived by the public to be so obviously bad that no political party thinks it can be seen to advocate additional borrowing (see here and here). So while the intellectual case for austerity crumbles, its political hold becomes stronger.

If you buy this reasoning, then it can be used as a justification for delegation, as argued here. However in this post I want to make a different point. Economists should take this kind of problem into account when they think about policy design. In the case of inflation, the popular misperception in part comes from, and is encouraged by, the identification in public discussion of inflation with consumer prices. So inflation targets are (always?) defined in terms of consumer prices. There is no compelling reason for this that comes from the macroeconomics literature, and there are plenty of proposals that involve focusing on either output prices or wages. [5] Given this, why not have an inflation targeting regime that involves a composite index: for example one that gave a third weight to the CPI, GDP deflator and average earnings.

The advantage of a composite target that involved wage inflation as well as price inflation is that it would help make the real meaning of inflation clearer in the public mind. [6] This in turn would make it easier for politicians to raise the inflation target if and when the economic case for doing so became clear. 


[1] There is a very nice study by Coibion, Gorodnichenko and Wieland (earlier pdf) which does this kind of exercise. Although it concludes that something like 1.3% is optimal, it all depends on the numbers, and you should note their assumption about how long a typical ZLB episode would last.

[2] There may be other examples of countries that have explicitly raised their inflation target, but I know of only one other case, and that is New Zealand (the pioneer of inflation targeting). There I believe the target is designed to be revisited in periodic ‘negotiations’ between the government and central bank. In 1996, the target inflation range was raised from 0-2% to 0-3%.   

[3] What seems fairly clear is that in most representative democracies in the last 30 plus years the unemployed have very little political power. So policies that increase unemployment meet very little resistance. Any natural sympathy from the employed is countered with talk of the ‘workshy’.

[4] This misapprehension may be partly based on real experience, due to nominal wage rigidity. With nominal wage rigidity, unexpected increases in inflation will reduce living standards. However that association is inappropriate to any discussion of a long run inflation target.

[5] Of course nominal GDP targets would involve output prices rather than consumer prices. I have suggested, in the specific context of current UK policy, a nominal wage growth target, and a champion of nominal GDP targets also prefers these.

[6] I wonder if there is a similar trick that could make fiscal stimulus more acceptable, particularly following a boom and bust where the boom involved excessive private sector borrowing. Perhaps by establishing a ‘borrowing reserve’, which was in effect just an amount that could be borrowed on condition - say - interest rates were at the ZLB. Any borrowing would have to be paid back at some pace when the economy was not at the ZLB.  


  1. From memory, Shiller and Akerlof estimated in their 'Animal Spirits' (2009) that a 0% inflation target in the US rather than 2% would make 1.5 million people unemployed.

    I know that Shiller did tests and found that people prefer a 2% pay rise at 2% CPI, rather than no pay rise at 0% CPI. So it follows they'd be happier with a 4% pay rise at 4% CPI!

    Also, a graph of UK debt since the 1680s on the BBC would help put things in perspective on that front.

  2. I would suggest that a reason why 'the public' resists increasing inflation targets relates to the perceived impact. Even if most people can be convinced that an increase from 2% to 5% does not automatically mean Zimbabwe or Weimar Germany, the fact remains that if real incomes are to be maintained 'someone' has to do 'something'. For most of us, particularly in the absence of organised unions in most of the workforce, it is not at all clear that 'someone' will in fact do anything. Even if your income depends on the Government, no one likes being the subject of apparently arbitrary decisions to increase pensions or other benefits, or even the wage of public sector workers (I speak from experience).

    Moreover, even if this springs from the somewhat irrational fear of change (we most of us want to protect what we have more than we want to increase it) the actual views are not irrational. It would be quite credible, though I don't have a source, to posit that the widespread drop in real income among the lower-paid in the US has been via the largely uncompensated effect of inflation at least as much as through deliberate wage cutting. Sticky wages again!

    Finally, I remember reading that the 30's were actually quite good times if you had a job as the declining price level meant rising real incomes for many of the 'haves'. So taking all this together, the perfectly valid macro-arguments that some inflation is necessary for the economy to work can very easily be drowned out by the multiple risks that any individual (and not only the 1%) could rationally foresee in his or her case.

  3. Here are a few things:

    The idea that a rise "inflation" does not automatically include wage increases is not some crackpot popular doctrine invented by the rubes. Back a couple of years ago when I first noticed a lot of people explicitly arguing for increasing the inflation target, I would ask them what they meant by that. And I was often explicitly told that the aim was to raise consumer prices and not wages, so as to improve competitiveness and exports. And I have often been explicitly told by economists and economics writers that inflation should be measured by the CPI!

    Economists need better measures of inflation, so that the prices of everything that is bought and sold in the economy - commodities, consumer goods, labor, financial assets, everything - are given appropriate weight according to the volume of those purchases in the economy. If you want, invent a new name for it like "gross monetary payments" or the "monetary payments indicator".

    And don't use NGDP. To measure inflation of the right kind we need to do more than measure payments for final goods and services, whether in real or nominal terms. If the price of anything, anywhere is going up while all other prices remain the same, then there is some kind of inflation happening.

    But in recent months, people who have suggested alternate metrics have been chased off, because this was viewed as some kind of plot to undermine the asset purchase program.

    Finally, with a better measure, people need to think much harder about exactly what kinds of tools would be needed to target the rate of inflation. Suggestion: they are not just central bank tools. Also, hitting a target for a crude mean rate is compatible with all sorts of deviations of specific prices from that rate. How do we target inflation so as to make it as uniform as possible?

  4. Having just spent a fortnight with my dear old mother in England, I know exactly what you are talking about. Mother really doesn't like inflation, and kept complaining about it. I didn't even try to argue with her. I think she would even switch to voting Labour if Labour promised a lower inflation target than the Conservatives.

    Switching to an NGDP target would reframe the debate over inflation. We could all then agree with my mother that inflation, conditional on the NGDP target/our money incomes, is indeed a bad thing that makes us worse off and is caused by lots of little supply-side factors.

  5. You make very good points. Who sold the idea that inflation is everywhere bad?
    People are more OK with inflation if it is rising wages that is pushing prices rather than rising prices with wages trailing badly behind.

    In the US economy, many policies, such as large student loans, can be more easily justified by higher wage inflation. The benefits differ if loans are paid off from wages that are rising at 4 percent per year rather than 2 percent. The US can't even get to 2 percent wage inflation. Lack of wage inflation makes loans more difficult to pay off.

    People think that high inflation has consequences. Well, low inflation has consequences, too. At low inflation, it takes longer to reset relative prices. In an environment where relative prices need major adjustments, low inflation impedes progress.

    - jonny bakho

  6. Excellent, thought-provoking post. The problem is that people demagogue the issue, even people on the ostenisble left who dislike monetary policy like Kervick above in the comments.

    I would take the 1970s over today, but in the corporate media and in academia the 1970s are likened to the Great Depression as a very bad time. In the US, part of it is the Volcker allegedly had to slam on the brakes very hard, so that the cure is cast as just as bad as the disease or worse.

    Regarding politicians, there's an anecdote about Obama, which the American rightwing considers a Kenyan-Muslim-Marxist, early on in his presidency where he told economics advisor Romer that he believed monetary policy had "shot its wad" in reference to old-timey musket rifles. She tried to educate him but he never made monetary policy a priority.

    Recently he gave an interview with the NYTimes where he discusses the Fed chair nomination and he mulls over the dangers of inflation and "froth." The danger now is deflation as Bernanke has discussed. And even if inflation was a danger labor is so weak it wouldn't be able to negotiate wage increases in its contracts as it did in the 1970s helping the wage-price spiral.

  7. 1. Have a look at what happened in the US and Japan when the target was raised. Rates all over the board went up.
    2. In Germany now a releted discussion has started that savers in the North are punished for the low rate policies of the ECB (who gets the blame, probably rightly btw).
    This doesnot looks to be an enviroment in which other things remain the same. Probably it simply all takes too long.
    3. Macro economists have become more and more replacement politicians. With also seen the lack of knowledge with the general public makes them uncredible for the other side at best. At worst uncredible for large groups like politicians.
    With most media macro figures being lefties the field is not taken seriously by a lot of people and increasingly so. It simply seems to be more and more 'sociologished', as such a great field, but nobody takes it serious anymore. With the public (and subsequent the politicians) not able to form an opinion for themselves on the quality all is nearly simply is dumped in the bin (even the good stuff).
    Imho highly important if politics are kicked out of the field. Made sure that stimulus is reversed (few trust the government on that seen the sort of new policies). And the counter measure say a tax increase is not dumped with another group that is benifitting most of the stimulus. It has to work macro but also in the layer below that.
    Especially now a lot of the people that are the 'face' of the field are from the group that is likely the worst if you want to sell something mainstream politically (70-80s style lefties, now usually in suit). Simply the most unpopular (general) group in society. Has been different likely will change but not the coming years. In other words if you want a measure not to be sold to the public have a lefty do the selling.
    4. If you want to take it away from politics, politics first will have to mess things up. Or said better politics should be seen as such by the general public. Not like the present crisis where they messed it up and banks (rightly) and hedgefunds (not the most popular guys, and so an ideal scapegoat, but hardly to blame for the crisis) got the flak. While politics who messed with BCBs/regulators (and the banks) escaped more or less. Otherwise it is a too interesting instrument to gives some goodies to their voters.
    5. This crisis very little will happen. Austerity discussion is simply 90% academic and imho pretty useless will change very little or nothing and as the endgame is still uncertain lessons are difficult to be drawn.
    Austerity is no austerity with governments spending overall in real terms more than ever before. And anti-austerity is the old austerity with the stufff that politically could not be sold anyway, 90% rhetoric . Waste of energy. Better look for something for the future that will work. Now we are going to so called anti austerity (see above) that will not work from austerity that didnot. Better not get associated with that as it is likely to fail.

  8. You'll have trouble implementing something which "would help make the real meaning of inflation clearer in the public mind" if it is initially incomprehensible to the public mind and therefore unsaleable,

    Oh, and inflation is bad for all things except house prices.

  9. Brilliant (as usual). When reading the post footnote 5 came to my mind. I incorrectly guessed that the proposed solution would be nominal GDP targetting. That would set money illusion against the identification of inflation with declining real wages and maybe get the political debate somewhere neare sensible.

    I think your idea is better. I think it would be better to be even more extreme and target wages.


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