Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday 6 November 2014

A comment on Kocherlakota's suggestions for clarifying monetary policy objectives

In a recent speech (HT MT), Narayana Kocherlakota (who helps set US interest rates) makes two suggestions to clarify what US monetary policy is trying to do. The first I completely agree with. The Fed should make clear that the 2% inflation target is symmetrical. Inflation at 1% is just as much of a problem as inflation at 3%. We only need to look at the Eurozone to see the dangers of asymmetry (which in their case is explicit).

His second suggestion is that the Fed should articulate a “benchmark two-year time horizon for returning inflation to the 2 percent goal.” You can see why Kocherlakota is suggesting this change, particularly in the current context. A target which is only going to be achieved in the indefinite long term may cease to have value. However applying the two year benchmark to just the inflation target may create inappropriate pressures in different circumstances.

The UK’s Monetary Policy Committee operated until quite recently what appeared to be exactly this two year benchmark. As evidence for this, here is a chart of the Bank’s own forecast for inflation two years ahead. (The dates refer to when the forecast was made.) The inflation target was 2.5% until 2003, and 2% thereafter.

Until the Great Recession, the forecast was generally pretty close to the target. Since then, the dates on which inflation two years ahead was expected to be below target roughly correspond to dates on which the Quantitative Easing (QE) programme was expanded. (More details in this post.)

The problem with this strategy emerged in 2011. As a result of the delayed impact of the 2008 depreciation in Sterling, increases in sales taxes (VAT) and higher commodity prices, actual inflation briefly exceeded 5% in 2011. As a result, in 2011 the MPC came pretty close to following the Eurozone in increasing interest rates. (For a number of months, 3 MPC members voted to raise rates, and the remaining 6 voted for no change.) A major concern of those who voted for higher rates was that inflation would not fall back to 2% within 2 years, and that as a result the credibility of the inflation target would be damaged.

So the 2 year time horizon came close to having a very damaging impact in the UK. (Arguably it did cause some damage, because it inhibited additional QE.) Now it is of course true that the combination of cost-push shocks experienced by the UK during that period was unusual, but even if rules allow for opt-outs in exceptional circumstances, they can nevertheless exert inappropriate pressure in those circumstances. Arguably the 2013 paper issued by the UK Treasury on monetary policy was at heart a message to the Bank to no longer apply the two year ahead rule.

Luckily there is a simple way of avoiding this danger, by making a small addition to Kocherlakota's suggestion. This is to apply the two year time horizon to both the inflation target and the output gap. I can see no convincing argument why the two year horizon should not be applied to both elements of the dual mandate. The problem in the UK arose partly because the UK does not have a dual mandate. If it had had this dual mandate, and the two year horizon had applied to both elements of the mandate, then the pressure to raise interest rates in 2011 would have been much less. (Few expected the UK output gap to close by 2013, even without interest rate increases.)

There is a more general argument that is completely independent of what happened in the UK. Whatever the intention, if the two year horizon is applied to only one element of the dual mandate, there is a danger that it appears to give priority to that element over the other. So my own opinion, for what it is worth, is that Kocherlakota's suggestions are a good idea, as long as the two year time horizon benchmark is applied to both parts of the dual mandate.    


  1. Quick question: in standard economic theory, is the inflationary impact of currency depreciation temporary? Intuitively, I would see it as temporary (a one-off adjustment in price levels), so what model was used by MPC members who voted to increase rates in 2011?

    1. Ian, this post dissects the facts at the time inflation was a "bother":

  2. There's a complicating factor here, Germany had a mild balance sheet recession in the corporate sector in the early 2000's (see Koo), in absence of fiscal expansion or a mortgage bubble (difficult given germany actually has a housing market that actually delivers cheap housing and a low ownership rate) beggar thy neighbour relative wage policy was the "only" option within the Eurozone.

  3. "The first I completely agree with. The Fed should make clear that the 2% inflation target is symmetrical. Inflation at 1% is just as much of a problem as inflation at 3%."

    1% core inflation is certainly a problem. It would indicate the economy is in danger of falling back into recession.

    What would be the danger of 3% core inflation? Returning to normal levels of GDP growth not seen since the late 1990s? Can't have that, now can we?

    One has to wonder how much longer the people will suffer neoclassical ideologues mucking up the economy. I don't see it going on forever.

    Either the bankers will blow the recovery by raising interest rates too soon (which the pseudo technocrats from various central banks are eager to do.) Or else a third boom-to-bust economic cycle will emerge and wreak havoc yet again. (Back in the Keynesian era boom-to-bust business cycles were eliminated — but obviously Keynes didn't know what he was talking about.)

    If you don't change the system, you won't get a different outcome. As Einstein said, the definition of insanity is trying the same thing over and over again expecting different results. Time to relegate free-market ideologues back to the lunatic fringe where they unhappily resided during the successful post-war Keynesian era.

  4. The problem might be if output adjusts more quickly than inflation. Plus, there's a bit of ambiguity in the targeting horizon for inflation, simply because it's a year over year measure. The BoC interprets "2 years" to mean: the rate of change of P between 12 months from now and 24 months from now.


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