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.

The Divine Coincidence in a parallel universe

The Divine Coincidence is the idea that by controlling inflation we also bring the output gap to zero, so we do not need separate targets for both. I talked about this in a recent post, but in writing that I realised I could make my point in another (and perhaps more effective) way. The Divine Coincidence essentially works both ways. So imagine a parallel universe where the monetary authority targeted the output gap, and not inflation. [1] [2] The authority said that by targeting the output gap they also controlled inflation.

Now you may make a practical objection at this point, which is that it is obvious to target inflation rather than the output gap because the latter is so difficult to measure. I think that argument becomes weak once we recognise that by targeting inflation, we are in fact trying to reduce the costs of inflation, and the published inflation rate may be a poor indicator of these costs. In a Woodford type framework, for example, inflation is costly because prices are sticky, so we should focus on those goods (and labour) where prices are sticky. This is one rationale for looking at core inflation, but core inflation is hardly a perfect measure of sticky prices. Arguably our proxies for the output gap, like unemployment, are at least as good at capturing the true costs of a non-zero output gap.

In this parallel universe they too had a Great Recession, and (being parallel and all) their recovery was of a very similar shape to ours. How would the output gap targeting monetary authority in this parallel universe perceive its performance? The story would be one of complete failure. After six years of trying, the output gap had still not been closed. A huge amount of resources had been wasted as a result. In fact, I suspect by now the monetary authority would have said quite explicitly that it just did not have the tools to do its job any more. Furthermore, they probably would have made it clear that one reason they did not have the tools (i.e. why interest rates were still stuck at the Zero Lower Bound) was because of fiscal austerity. If they did not try and blame someone else, they would look utterly incompetent.

I do not think, in our inflation targeting world, the monetary authorities have this view. Instead, based on the limited information I have, and at least outside the Eurozone, they believe performance over the last six years has not been too bad. Inflation was a bit high around 2011, and is maybe a bit low now, but nothing too serious. Yet the data they are looking at is exactly the same as the data in the parallel universe. The only difference is that they are targeting inflation, while in the parallel universe the focus is on the output gap. And by the Divine Coincidence, this difference should not matter!

My parallel universe idea illustrates two points. First, over the last six years, the Divine Coincidence has been distinctly unholy. Second, as a result it is terribly misleading to focus on inflation (and consumer price inflation in particular) rather than the output gap. I suspect in thirty years students will look back on this period with the same disbelief that we look back on the 1930s. How could they have allowed the recession to continue for so long, they will ask, when they had the tools to do much better? Part of the answer will be inflation targeting.

   

[1] It’s not quite that simple, because with either a traditional or New Keynesian Phillips curve, getting inflation to target ensures a zero output gap, but a zero output gap alone does not ensure hitting the inflation target. However I do not think this point is crucial here.

[2] Because of the dual mandate, the US Fed could in principle be in either universe. In practice they seem to focus on inflation.