Raising the inflation target

The argument for a higher inflation target is straightforward, once you understand two things. First the most effective and reliable monetary policy instrument is to influence the real interest rate in the economy, which is the nominal interest rate less expected inflation. Second nominal short term interest rates have a floor near zero (the Zero Lower Bound, or ZLB). Combine the two and you have a severe problem in a recession, because to combat the recession real interest rates need to move into negative territory, and how far they can go into that territory is limited by the ZLB. That means monetary policy alone may be unable to get us out of a recession.

Raising the inflation target reduces the likelihood that interest rates will hit the ZLB. To see why, note first that the long run (economists often say ‘equilibrium’ or ‘natural’) real interest rate is positive. Let’s say it is 2%. If the inflation target is 2%, and the ZLB is 0%, that would mean that in normal times the average nominal interest rate is 4% (2% inflation target + 2% to get to a 2% real interest rate). That means nominal interest rates can be cut by a maximum of 4% if the economy falters. That may be enough for a mild downturn, but as we saw in 2008 it is not enough for a major recession. However if the inflation target was 4%, nominal rates would now be able to fall by a maximum of 6%. That is probably enough to combat all but the worst kind of recession.

Why are many economists currently arguing that we should raise the inflation target from 2% to 4%? One of the reasons is that we now believe the long run real interest rate is currently lower than it was when the 2% target was first chosen. (This is sometimes referred to as secular stagnation.) If you go through the arithmetic above, you can see why a lower long run real interest rate will make the ZLB problem worse. The argument is that we now need to raise the inflation target to make sure we hit the ZLB less often in the future.

This issue moved from an academic discussion to a real possibility in the US a few days ago. When Fed Chair Janet Yellen had been asked about raising the inflation target in the past, she has tended to dismiss the idea. However she now says that it is something that the Fed will review in the future, and that it is one of the most important questions facing central bankers today.

This will undoubtedly give new impetus to the debate over whether the inflation target should be raised. We are in standard trade-off territory here. Economists generally agree a higher inflation target will in itself inflict greater costs on the economy, but they bring the benefit that the ZLB problem will occur less often. But there is an alternative, and clearly much better way out of this dilemma.

Governments have another instrument that has a reasonably predictable impact on aggregate demand, and which can be used to combat a recession: fiscal policy (changes to taxes and government spending). In the UK at the moment interest rates are at the ZLB in part because fiscal policy is contractionary (austerity). It would be far better to use this instrument to stimulate the economy in a recession than to raise the inflation target. Yet the institution of independent central banks have discouraged governments from using fiscal policy in this way.

It is no good central banks pretending that this is something which is up to governments, and that there is some unwritten law which means that central banks should keep quiet on such things. In reality, in both the UK and the Eurozone, the central bank actively encouraged governments to do the wrong thing with fiscal policy in the last recession. In other words, they encouraged austerity. If there is something inherent in the institution of a central bank that makes them give inappropriate advice in this way, then we should be asking how central banks can be changed as a matter of urgency.

What should happen in a recession, as soon as the central bank thinks that interest rates will hit the ZLB, is that central banks should say, out loud in public, that fiscal policy should become more expansionary. In addition central banks should say, out loud in public, that governments need not worry about rising debt and deficits due to the recession and any fiscal stimulus they undertake spooking markets because the central bank has that covered. Both statements have the merit of being true. 

Of course governments will need to restore debt to desired levels at some point, but that point should be well after interest rates have left the ZLB because then debt correction can be painless. The immediate aim of fiscal policy in a recession should be to allow interest rates to rise above the ZLB as soon as possible. That gives you the best macroeconomic outcome, and one that is far superior to raising the inflation target. The most important question facing central bankers today is why they failed to do that from 2009.

Now it is possible that, if democracy is in a bad shape (as it currently is in the US for example), the government may ignore the advice it receives from the central bank. In that case it is worth considering giving central banks some additional power to mimic a fiscal expansion, such as helicopter money for example. Or it may be worth considering institutional changes that allow nominal interest rates to go negative. Or raising the inflation target. But before doing any of those things we need to ensure that central banks give the right advice to governments when the next recession comes along.

Radical macro lessons from the Great Recession

The relationship between NGDP targets, a higher inflation target and helicopter money

Just suppose that lower oil prices help generate a period of significantly above average growth in the OECD economies over the next five years. We avoid deflation, but despite more rapid growth modest increases in interest rates keep inflation at or below target. Even if this happens, the story of the Great Recession will not have been a happy one. If you compare where we are now to where we might have been without a financial crisis, there remains a huge gap. Even if we go a good way to closing that gap over the next five years, this very gradual recovery will have cost us dear. In some countries (most of the Eurozone) that cost is currently reflected in high levels of unemployment, while in others (the US) it manifests itself in real wage stagnation or decline. (The UK is now in the latter group: if you are bored with hearing this from me, see this from John Van Reenen.)

Are there lessons to learn from this? You can probably divide economists into two camps at this point. One group, the ‘supply group’ - which would include most of those setting monetary policy - tend to think that we have largely done the best we could under the circumstances. By circumstances, I mean two related things: a rather surprising increase in inflation during 2011, and an apparent decline in the ability of the ‘supply side’ of the economy to grow at the kind of rates we might have expected before the crisis. While the former is undeniable, the second is conjecture, because we cannot observe the key driver of long term growth, which is technical progress.

The second group of economists attribute more of the slow recovery since the financial crisis to deficiency in aggregate demand. I am in that second ‘demand’ group, and have argued that fiscal austerity is responsible for a great deal of the slow recovery. Implicit in such arguments is the idea that had demand been strong, any further increase in inflation around 2011 would have been modest and temporary, which with wise monetary policy need not have led to any increase in interest rates.

I think most of the demand group also share a view that it would be a large mistake to shrug off this bad experience as a one-off, or as something that only occurs every century or so. The ‘one-off’ story could focus on an unfortunate misreading of the Eurozone crisis: however, while this might explain the change in attitudes is some important institutions like the IMF, it is less plausible in explaining why policy makers around the world switched to austerity. The ‘every century’ idea is wrong because it fails to note the changes that have been brought about by the widespread adoption of 2% inflation targets, coupled with a view that the ‘natural’ real interest rate is also likely to remain low for some time.

Different members of the demand group have proposed three different and radical innovations in macroeconomic policy to help avoid this kind of mistake happening again. These are targeting the level of nominal GDP (NGDP), raising the inflation target, and some form of helicopter money. Are these innovations alternatives or complementary to each other?

There are some (notably market monetarists) who seem to argue that changing monetary policy to NGDP targets is sufficient. My own view is less optimistic. A clear advantage of NGDP targets (and not its only advantage) is that they would create expectations of a more expansionary policy during and after the recovery phase from a recession, but in my view this would not be enough to prevent liquidity traps happening. This is because I see the problem of the liquidity trap (nominal interest rates being unable to fall below some lower bound around zero) as central to why the Great Recession was so prolonged, and episodes where we experience a liquidity trap as becoming more frequent because the inflation target (explicit, or implicit within the NGDP target) is low.

Raising the inflation target is an obvious way of reducing the frequency of liquidity traps. If the natural real interest rate is 2%, for example, then with a 4% inflation target, the nominal interest rate has much further to fall before the lower bound is reached than if the inflation target was 2%. It is important to note that this argument does not preclude adopting a NGDP target, because any target path for NGDP includes an implicit inflation target. For that reason, you can view NGDP targets and a higher inflation target as either complementary or alternatives, where the latter is true only if you think one device does the required job by itself.

Helicopter money is essentially giving the central bank an additional instrument - a form of fiscal stimulus. In that sense it is rather different from NGDP targets or a higher inflation target, because it involves instruments rather than the objectives of monetary policy. For that reason, in principle it could be a complement to both the other radical suggestions. In a way helicopter money is best seen as an alternative to Quantitative Easing, and there is no reason in principle why QE is not compatible with NGDP targets or a higher inflation target. It is possible of course that if helicopter money was shown to be effective in dealing with liquidity traps, then it would make the case for other radical changes less compelling.

If I’m being realistic, I think that if the first sentence of this post turns out to be true, the chances of any of these radical changes being adopted before the next liquidity trap episode are very small. A period of strong growth will be sufficient for policy makers to pretend that the slow recovery from the financial crisis was either a one-off or the best that could be done in the circumstances. Instead I suspect that as the economy moves ever closer to its pre-crisis trend, the demand group of economists will convince more of the supply group that they were wrong. This will give greater credibility to the idea that radical changes to policy are required, and each alternative will receive greater analysis and probably greater support amongst economists by the time the next liquidity trap episode occurs.