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.