Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday, 22 October 2015

The last 7 years are an argument against inflation targeting

The big controversy since the Great Recession began has been about fiscal policy: government spending, taxes and the budget deficit. In contrast monetary policy has not hit the headlines so much. This is understandable: while fiscal policy has oscillated from fiscal stimulus in 2009 to fiscal austerity in 2010, once the recession became clear (to some earlier than others) monetary policy in the UK, US and Japan appears to have been unambiguously expansionary, with interest rates staying at historical lows. The ECB is the exception, raising rates just before a second Eurozone recession.

Look a little closer however and we find something rather more worrying. Most people who base their view on economics rather than politics would regard the recovery from the Great Recession as disappointing. We have got particularly good reasons to be disappointed in the UK, but many economists think the US and Japan could also have done better at reducing unemployment more rapidly. More worrying still, the recession and the slow recovery may have caused permanent damage. (See Antonio Fatás here on his work with Larry Summers.) In the UK in particular we appear to have permanently lost a massive 15% of income during the recession. That kind of loss over a 7 year period is totally unprecedented in peacetime.

There are well known mechanisms by which short term output losses could lead to a permanent reduction in output capacity, known collectively by economists as hysteresis mechanisms. They include deskilling of the unemployed, less capital and less capital embodied technical progress. Just how permanent they are varies by type, but they all involve real costs in terms of lost output. One that worries me a lot is how expectations about trend output get downgraded, which can become self-fulfilling for quite some time.

The people whose job it is to make sure recessions are short-lived and these kinds of mechanisms do not take hold are in central banks. Yet if you ask monetary policy makers what they think about the last 7 years, they will not hang their heads in shame. They will not say it has been a disaster, but what more could we do? They will not say that, with interest rates near zero, they were powerless to do much, because unconventional policies like Quantitative Easing were poor instruments and government fiscal policy was moving in the wrong direction. Instead they will probably say that overall the last 7 years have not been too bad. This very different view seems both odd and worrying.

The reason however is straightforward. Monetary policy makers either regard their primary target as inflation, or are explicitly told that inflation should be their primary target. While below target now, inflation was above target in 2011 and 2012, so on balance maybe the record is not too bad. So looking at what they were asked to do, monetary policy makers feel little remorse.

In the UK we can put this in a rather startling way. Imagine someone in 2011 discovered a magical new policy instrument that was guaranteed to stimulate the economy, and gifted it to the Bank of England. In all probability they would not have used it. For four months in 2011 three members of the MPC voted to raise rates. We were just two MPC members away from following the ECB’s disastrous course. Just because we avoided that calamity by a whisker does not mean we should pretend it didn’t happen.

This all comes down to what economists have called the divine coincidence. This is the idea that you do not need to target both output and inflation. Ensuring that inflation is on target in a considered way (by for example looking at inflation two years ahead) will stabilise output as well. While the US central bank has a dual mandate (essentially both inflation and output), central banks that were made independent later (like the Bank of England) have inflation as their primary target. One of the main reasons for this was a growing belief before the Great Recession that the divine coincidence would hold. Target forecast inflation and output will look after itself.

The idea of the divine coincidence has not had a good recession! As I explained in one of my better posts, if the divine coincidence worked a central bank in a parallel universe that targeted the output gap rather than inflation should feel exactly the same way about the last 7 years as our inflation targeters. Yet as I explained there and above they would instead feel ashamed and frustrated. We know there are good empirical reasons why the divine coincidence might break down when inflation is low: resistance to nominal wage cuts will mean that monetary policy makers targeting inflation in a recession will overreact to positive inflation shocks like oil price increases and underreact to below target inflation. Add hysteresis, and you can get lasting damage.

So one lesson of the last 7 years must be that relying on the divine coincidence is a mistake. A primary goal of the central bank is to end recessions quickly, and giving it a single primary target of inflation can detract from that. One obvious improvement is to give the central bank a dual mandate, although the best way to specify that is not clear. Another possibility is to combine output and inflation into a single target, and yet another is to raise the inflation target to a level where the divine coincidence might still hold. Luckily for me I have thought quite a bit about these questions already, but in the next few months I may need to come off any fences that remain.


  1. " Luckily for me I have thought quite a bit about these questions already, but in the next few months I may need to come off any fences that remain."

    This review of the BoE mandate, is the committee taking views of the public into account, i.e.,ask for contributions to the review?

    For example, including asset price inflation in the inflation target.

    So for example, if the inflation figure to be targeted by the BoE would be made up of 50% CPI inflation and 50% house price inflation, the policies of the BoE would have looked a lot different.

    Any chance that this might happen? Any chance to officially propose something like that to the review, for it to be officially considered?

    1. Danny Blanchflower is in charge, and I do not know what the formailities will be, but there is nothing stopping anyone making their views known to him.

      On asset prices I at least have to be convinced. There is a more general issue of whether financial stability should also be in the remit, and my concern on that can be summed up in one word: Sweden.

  2. A primary and secondary target system could be good. The primary target can be growth, but it would be a growth rate at which prices stay stable (0% inflation). Whenever the two targets are in conflict, growth is targeted.

    1. Or maybe something like output stabilisation being the objective, but undertaken in a way that achieves 2% (or whatever) inflation in the medium term.

  3. The fact that unemployment rises does not necessarily mean there is an output gap – at least in the following sense. After a large shock like the 2007/8 crisis the economy may be disrupted for several years, thus it may be that any rise in demand simply stokes inflation rather than raises real output, until everything settles down again.

    If I’m right there, then a better solution is to force banks to have such large capital ratios (e.g. the 30% or so advocated by Martin Wolf and Anat Admati) that it’s virtually impossible for them to collapse.

  4. Robert Shiller's paper of behavioural economics HUMAN BEHAVIOR AND THE EFFICIENCY OF THE FINANCIAL SYSTEM February 1998 had it that:

    "Mental Compartments. Related to the anchoring and framing phenomena is a human tendency to place particular events into mental compartments based on superficial attributes. Instead of looking at the big picture, as would be implied by expected utility theory, they look at individual small decisions separately."

    Next up in the article is:

    "Overconfidence, Over- and Under-Reaction and the Representativeness Heuristic. People often tend to show, in experimental settings, excessive confidence about their own judgments."

    The paper finished with this:

    "Heeding the lessons of the behavioral research surveyed here is not going to be simple and easy for financial researchers. Doing research that is sensitive to lessons from behavioral research does not mean entirely abandoning research in the conventional expected utility framework. The expected utility framework can be a workhorse for some sensible research, if it is used appropriately. It can also be a starting point, a point of comparison from which to frame other theories. It is critically important for research to maintain an appropriate perspective about human behavior and an awareness of its complexity. When one does produce a model, in whatever tradition, one should do so with a sense of the limits of the model, the reasonableness of its approximations, and the sensibility of its proposed applications."

    Are central bankers that different from financiers?

  5. The problem is the alternative is keeping 5% of the population unemployed in perpetuity?

    The ''borrow' a bit more to spend on infrastructure but not too much' is a sop to the corporate masters and keeping land prices up.

    There is nothing radical in this. You and the rest of NewKeynesians never say put the public purpose front and centre - then let the private sector use what is left.

    And in particular there is never a solution to deal with the people that the private sector choose not to use. They are just ignored, or at best thrown a few crumbs.

    No wonder the right wing keep pushing rightwards!

  6. There's a lot to unpack here.

    Thinking about monetary policy failure in the last 7 years, we should be careful to attempt to distinguish between failures of theory and failures in practice.

    I can imagine how the view from the UK, where core inflation was strong in the immediate aftermath of the crisis, coincident with productivity loss and tepid output growth, the divine coincidence would look dubious. It's a failure of theory to hold up in practice.

    In the US and the EU, by contrast, the central banks have consistently failed to hit their inflation targets. In the US where we have a dual mandate, the Fed has arguably failed to hit on either. That looks like a failure in practice. It's not an indictment of inflation targeting per se, but rather some central banks' inability to hit those targets, whether by weakness of will or absence of sufficient tools (another question subject to debate... )

    And in the UK in recent years, we've seen core inflation gradually sag, with a clear disinflationary trend even absent fuel price considerations.

    So where does that leave us?

    IMHO, it still looks first like a problem of central bank management being too passive and conservative. They have been willing to use unconventional methods like QE to stave off disinflation, but they do so in a way that gives markets every reason to believe they want to tighten at any moment. When inflation is too low they spend a lot of time talking about preventing it from going too high. This, I believe, is why they widely fail to hit their inflation targets.

    And the targets are too low. Lowering the real interest rate on short term debt *should* effectively stimulate the economy. The world would be a very strange place if that were suddenly not true. And if true, it means we can realize additional growth by lowering the rate, and the way to do that is with higher inflation.

    So for my part, to resolve the questions about central bank timidity and sufficiently negative real interest rates, I would favor: continued inflation targeting, but with a price *level* target (so the CB can't waffle year to year) and with a higher level than 2%. Maybe something like 3.5%.

    If that still didn't work ... then NGDPLT would be the next logical step.

    1. I think there are layers here. In the case of the UK and ECB having an inflation target allows monetary policymakers to neglect getting out of the recession quickly. But that does not mean that had this problem not occurred everything would be fine. They may not have had the instruments necessary to do much better. They may have been predisposed to treat targets asymmetrically, and perhaps lack of accountability meant this was allowed to pass. ( think both are true for the ECB,) All this may mean that changes may need to take place on various fronts before we can say for sure that the recovery would have been better under a different regime.

  7. I would change to an NGDP path level target. It would make it more difficult for the central bank, media and politicians to ignore the fact that the central bank was doing a bad job.

    A NGDP futures market could be set up with the market betting on and signaling how they feel the central bank is performing.

  8. Come off it Simon; divine coincidence, there is no such animal! Next you will be telling me that Ricardian Equivalence is real, despite there being no evidence whatsoever that it has actually occurred anywhere, ever. (Note to Governor Carney. Please shut-down the "Bank Underground" website, it is a laughing stock. Is anyone editing the BS posts on that site? Particularly now Mr Carney, you have started making political statements on behalf of the Conservative Party.)

    You say; "The people whose job it is to make sure recessions are short-lived and these kinds of mechanisms do not take hold are in central banks" Sorry, no they are not, those people are in the Treasury. "There is no financial crisis so deep that a sufficiently large tax cut or increase in public spending cannot deal with it." Warren Mosler, Mosler's Law.

    It's about time we switched off "monetary policy" and stripped down the BoE to its national / international payment, clearance and settlement function; particularly supplying cheap, if not free, trade credit for little companies waiting for big companies to pay them. The few emergency, economy wide, control mechanisms needed, can be easily handled by the DMO in the Treasury.

    1. If you have not already, have a listen to Yanis Varoufakis. Now, he is what we call an "Economist".

  9. Simon, better late than never!

    1. ?? If you bothered to look at the links you will see that I have consistently held this position.

    2. But only timidly and tentatively. Now you really "plunged"!

    3. I love the way NGDP advocates think they know what I research or what I think better than I do. What is timid about the May 2012 post entitled Inflation targeting is not working?!

  10. I thought the US central bank mandate was employment focussed rather than output? Unfortunately zero hour contracts and EU freedom of movement mitigate against a UK job guarantee providing a buffer stock?

  11. It actually has three mandates. The third one is moderating long term interest rates which usually just takes care of itself. This was added in the 1970's to combat stagflation.

    1. The mandates are in effect "sense of Congress" pious public-relations. They are not enforceable or even monitorable.

      In practice the real priorities of the Fed Board can only be discerned after the fact by careful and difficult analysis.

      My impression is that their number 1 priority is to facilitate the funding of the USA's wars, which is uncontroversial.

      Subject to that the number 2 priority is boosting the profits of the USA financial corporations as a whole, and recapitalizing it when it goes bankrupt, by ensuring high interest spreads and pushing up collateral valuations.

      Subject to that the number 3 priority is to keep wages down. But other bits of government policy probably take the lead in doing that.

      The above priorities are sometimes for the sake of appearances related to the official mandates in Fed Board-speak by sophistries, for example that "financial stability" is the premise for the official mandates, and that wages are "inflationary" while profits and rents and capital gains are not "inflationary".

      The priorities of the central banks of other anglo-american culture countries seem much the same as those of the Fed. There are however a few qualms by some people at the BoE as some minority of the UK establishment has not been yet totally compromised by the "sell side", by the financial speculators in the City.

  12. There appears to be a developing epidemic of TADD ( Target Attention Deficit Disorder ) - an inability to focus on the issues at hand due to distraction by diverse and exciting new "targets".

    U.K. and U.S. ngdp performance since the end of the recession is indistinguishable from that promised by ngdp ( or ngdplt etc ) targeters , i.e. , ngdp has been ramrod straight in log terms :

    So , if you're unhappy with the current ~4% ngdp growth path , and would prefer a 5% or 6% path , all you're really requesting is an upward shift in the inflation target. For all intents and purposes , we've been ngdp targeting since 1990 ( expand the graph above ) , and the break in the curves and downshift in "target" were inevitable results of the continuous effort to pull future demand forward via debt. Bad debt builds up and you need some to be cleared every now and then. We didn't clear nearly enough , but we will , sooner or later.

    When almost every major economy has a debt overhang , the export solution afforded by monetary policy becomes zero sum. Then you're left with either borrowing more growth from the future via releveraging , or simply taking your medicine. The 4% ngdp growth path chosen by the U.S. and U.K. represents a splitting of that baby , I suspect. For the U.S. , total nonfinancial debt/gdp has been stable since the crisis. If you add in the expansion in the monetary base ( debt of a different flavor , but debt , nonetheless - there's no free lunch ) there has been some mild releveraging. I'm guessing roughly these same dynamics apply to the U.K. :

    Get some ritalin for the TADD , and then try to focus on more important issues , like how MPC relates to leverage-stable circular flow ( as in pre-1980 ) , and how productive economies might be preferable to crony-capitalist casinos.


    1. «focus on more important issues , like how MPC relates to leverage-stable circular flow ( as in pre-1980 ) , and how productive economies might be preferable to crony-capitalist casinos.»

      Anglo-american voters in the middle classes much prefer those «crony-capitalist casinos» because they have been making 100%-150% yearly returns on leverage speculation in residential property, more or less government financed and guaranteed.

      Accordingly in the UK the rule is that governing parties win the elections if property prices have gone up, and lose elections if they have gone down, almost regardless of what happens to jobs, wages, rate of exchange, deficit or austerity, etc.

      That «productive economies» dream will only happen when the «crony-capitalist casinos» go cataclismically bankrupt, and financial corporates can not longer be seen as "magic money trees" (Chris Dillow's felicitous expression) by governments and their voters.

      An old quote from JK Galbraith's "The Great Crash 1929", written in 1954:

      «Just as Republican orators for a generation after Appomattox made use of the bloody shirt, so for a generation Democrats have been warning that to elect Republicans is to invite another disaster like that of 1929. The defeat of the Democratic candidate in 1952 was widely attributed to the unfortunate appearance at the polls of too many youths who knew only by hearsay of the horrors of those days. It would be good to know whether, indeed, we shall some day have another 1929.»

      «Yet, in some respects, the chances for a recurrence of a speculative orgy are rather good. No one can doubt that the American people remain susceptible to the speculative mood -- to the conviction that enterprise can be attended by unlimited rewards, which they, individually, were meant to share. A rising market can still bring the reality of riches. This, in turn, can draw more and more people to participate. The government preventatives and controls are ready. In the hands of a determined government their efficacy cannot be doubted. There are, however, a hundred reasons why a government will determine not to use them. In our democracy an election is in the offing even on the day after an election.»

  13. So I have waited a a few days and nobody has objected to this yet:

    «The people whose job it is to make sure recessions are short-lived and these kinds of mechanisms do not take hold are in central banks.»

    What??? No role for fiscal policy? That it is inly the job of central banks to end recessions by unleashing a wave of credit to push up asset prices, create massive capitals for the rich, some of which will "trickle down" is pure neo-liberal, media-macro orthodoxy.

    "Recoveries are always and everywhere a central bank job" to pair with "inflation is always and everywhere a monetary phenomenon"? :-)

    It is the more perplexing given the acknowledgement in the same post that fiscal policy ahem "exists": «fiscal policy has oscillated from fiscal stimulus in 2009 to fiscal austerity in 2010».

    And there is a grave omission here:

    «once the recession became clear (to some earlier than others) monetary policy in the UK, US and Japan appears to have been unambiguously expansionary»

    That fantastically loose credit and monetary policy has been driven not just by «he recession became clear» but by the reluctance of fiscal policy operators to do their job, and in particular to recapitalize a lot of bankrupt megabanks by fiscal means, leaving that job to central bank shysterism.

    «with interest rates staying at historical lows»

    That is also as usual rich with large omissions: the actual interest rates that ordinary people and businesses pay have barely changed, and rage from 15%-800%. Only relatively rich highly leveraged property speculators (also known as mortgagees) have seen interest rates fall somewhat, and near-infinitely leveraged financial speculators (also known as the financial system) have been given credit a nugatory rates to help them make massive profits to distribute mainly to their executives and trades.

    And what matters even more than the interest rate level is the availability of credit, where credit policy, and in particular leverage policy, has been amazingly loose. But rationed as mentioned above: only the bankrupt big donors and potential employers of government elites can borrow nearly unlimited amounts "guaranteed" by toxic collateral at the low low low interest rates that central banks offer only to friends-of-friends.

    1. «nobody has objected to this yet:»

      Oops, I missed "acorns" post. but it is still amazing that nearly all the commenters here, not just our blogger, haven't objected to the media-macro notion that anti-recession policies are just the responsbility of the central bank.

      Even notorious new-keynesian B Bernanke seems to disagree, while complaining about "fiscal dominance":
      «If people are unhappy with the effects of low interest rates, they should pressure Congress to do more on the fiscal side, and so have a less unbalanced monetary-fiscal policy mix. This is the fourth or fifth argument against quantitative easing after all the other ones have been proven to be wrong. And this is certainly not an argument for the Fed to do nothing and let unemployment stay at 10 per cent.»

    2. Good comments , Blissex. "Circular flow" is an outmoded concept , it seems. Nowadays , it's all about linear flow , from bottom to top.

      A couple of good articles that illustrate the pattern in business profits :


    There is good argument against targeting wage inflation here.


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