The inflation dragon is just around the corner

People who believe this are not confined to the US. In articles in the Telegraph and the FT (HT Frances Coppola), Andrew Sentance says the job of the new Governor of the Bank of England should not involve messing with the inflation target, but to “reassure the British public that under his governorship they can expect stable prices”, which he thinks probably means putting up interest rates and withdrawing QE this year. The article contains the inevitable reference to the 1960/70s: “We have been here before in the UK. A creeping tolerance of higher inflation in the 1960s paved the way for double-digit inflation in the 1970s and early 1980s.”

I would not bother with this if it was not for two things. First, Andrew Sentance was on the Monetary Policy Committee, and his persistent warnings then and since that CPI inflation would be higher than expected have been largely right. Second, the factors that have been helping to keep CPI growth high – commodity prices and fiscal austerity – are not obviously about to disappear, so the Bank of England may still be having to explain why they are ‘ignoring’ above target inflation through 2013.

There is a genuine puzzle about why the influence of the recession has not dominated the impact of these commodity and fiscal effects. Paul Krugman stresses the role of wage rigidity. My own pet theory for the UK is the influence of the financial crisis, but that is for another post. What has to be laid to rest is the idea that we are about to experience the 1960/70s all over again. Have a look at this chart.

It shows UK wage[1] and consumer price inflation over that period. For nearly every quarter before the inflation peak in 1974 it shows wage inflation above price inflation. We do not need to worry about whether one series leads the other as inflation increased – we can just say that both measures of inflation rose together. Hence the phrase ‘wage price spiral’ to describe what happened over that period. Now look at the same series since 2005.

Since the recession hit, we have seen a marked reversal: consumer price inflation has been above wage inflation. There is absolutely no sign of an imminent wage price spiral. (The data for wage inflation I use here comes from the OECD, but if we use the ONS’s average earnings index the latest numbers for Aug-Oct 2012 show wage inflation of only 1.8%.) The only remotely similar period since 1955 was the early 1980s, when inflation was rapidly falling. (Whether the behaviour of real wages over the recent period is unusual given unemployment is examined here.)

I can put the same point another way. If the Bank of England had been given a target for wage inflation as well as its price inflation target, that target would probably have been 4%, reflecting the normal (pre recession) divergence between the two series. If it had only been given a 4% wage inflation target (and there is no clear reason why this should not have happened), then given the numbers above I assume Andrew Sentance  would be complaining that the Bank of England had been doing too little to stimulate the economy. This just shows the danger of having a mandated target for just one inflation measure that I talked about here.

I suggested in a post a month back that if the Chancellor really wanted to stimulate the economy, he should replace the Bank’s 2% CPI inflation target by a 4% average earnings target. He has the power to do that today, and does not need to wait until the new Governor takes over. But the broader point is that any suggestion that current tolerance of above target inflation is leading us back into the 1970s is about as realistic as a world with dragons.

[1] Compensation of employees, source OECD via FRED. It is a real shame that the ONS website is not as user friendly as FRED. 

Is there a case for inflation targets? The UK versus the US.

One of my projects for the year ahead is to come off the fence (one way or another) on nominal GDP targeting. As an experiment, I’ll try and track my progress on this project with blog posts, although only if my thinking might be interesting to others. It is going to be a long process, because there is a lot involved: levels vs rates of change, GDP deflator vs CPI, nominal GDP versus its price component, and uncertainty about the natural rate to name some of the most obvious issues. However there is also another issue that may be just as important, and that is whether we need targets at all. In this post I just want to think about this last issue in relation to inflation targets, and not any other kind of target.

An obvious way for a macroeconomist to approach this is to imagine a world in which the central bank acts in society’s best interests, and has as good an idea as anyone else what those interests are. (The policy maker is benevolent, and knows the appropriate measure of social welfare to maximise.) Actually, for both the US and UK I do not think that is such a bad place to start. Let’s also suppose, as is standard, that society’s best interests involve getting inflation close to some desired level, and getting the output gap close to zero. Call this a dual mandate if you like. In such a world, why impose a target on the central bank? In other words, why do what is done in the UK rather than do what is done in the US?

By target, I mean something the central bank is required to try and hit. I am not talking about the central bank’s communication strategy. I take it as given that it is a good idea for the central bank without targets to be transparent about what its goals are, including what it thinks the desired inflation rate is. That is why this is effectively a comparison between the UK and US where in both cases transparency is fairly high.

The standard academic story involves time inconsistency and inflation bias. (Those familiar with this can skip the rest of this paragraph.) Essential to the inflation bias story is that a positive output gap (output above trend) is better for society than a zero output gap, for given levels of inflation. If you think this is obvious (more output is always better), remember more output means people working longer hours. If you think a zero output gap must be best, think about monopoly distortions or the impact of distortionary taxes. If a positive output gap is best, then a central bank may be tempted, once inflation expectations are formed, to try and temporarily raise output above the natural rate, knowing that the impact on inflation will be modest because inflation expectations are given. However rational agents will anticipate this, and the implication that their expectations about inflation will therefore be wrong. So they raise their inflation expectations above the central bank’s desired level, to a point at which the central bank no longer wants to raise inflation still further to get a positive output gap. The difference between this level of inflation and its desired level is inflation bias.

Although there is a huge literature on this, I have never been that persuaded of it’s continuing relevance in a world of long standing independent central banks. Central bankers, or academics on the UK’s Monetary Policy Committee, know that it is foolish to try and go for a positive output gap in this way, so they will avoid doing so. If the public nevertheless thought otherwise and therefore set inflation expectations above desired levels, the central bank would not settle for the inflation bias equilibrium (the time consistent or discretionary equilibrium), but would deflate the economy to get inflation down. This would soon convince the public that it was not trying to achieve a positive output gap.

Even if I’m right on this, we can still use the inflation bias argument in reverse. By this I mean that the public in ignorance will want the central bank to raise output above the natural rate, and the inflation target protects the central bank from this pressure. I mention this not because I think it is that convincing, but because this ‘using targets to protect the central bank from public pressure’ argument may have much more validity when we come to level targets. Of course the time inconsistency problem is more general than just inflation bias, but effects how the monetary authority responds to shocks (often called stabilisation bias), but here again levels targets may be more useful than inflation targets. 

I suspect the actual reason for inflation targets where they exist is more political. They increase the accountability of the central bank, and in some cases (like the UK) they allow politicians to set the target. These may be important advantages, particularly at the beginning of a new policy regime.

I also suspect that many macroeconomists have traditionally assumed (as I did) that the costs of inflation targeting were small, because if that target was achieved flexibly, it was quite compatible with optimising some combination of inflation and the output gap. The reason is of course the Phillips curve, which says inflation cannot be stable in the medium to long term if the output gap is non-zero. So a regime that targeted some fixed inflation target over the medium term would automatically achieve a zero output gap over the same time horizon.  Flexibility means leaving the choice of any particular short term combination of excess inflation and non-zero output gap up to the central bank.

This rather sanguine attitude has been tested by recent events. Some countries have experienced a whole series of positive inflationary ‘shocks’, some of which just reflect fiscal policy decisions. In the UK this has exhausted any flexibility that the MPC may have felt they had in not meeting the inflation target, so that their plans now involve meeting that target (or, indeed, expecting to slightly undershooting it), even though they forecast a large negative output gap to persist. Aiming to achieve the inflation target conflicts with what a benevolent policymaker would do. In contrast, the Fed in the US has (albeit only recently) explicitly countenanced exceeding their desired inflation level in an effort to get the output gap down. In other words, the inflation target in the UK is stopping the MPC doing what the Fed signal they are prepared to do.  

As a result, monetary policy in the US is better than in the UK, as a direct result of the impact of the inflation target in the UK. A related problem is the measure of inflation used. As I have pointed out before, the CPI is particularly susceptible to inflationary shocks like tax changes or higher commodity prices. As it is not obvious what the correct measure of inflation is from a welfare point of view, focusing on a measure that over a period is persistently higher than others may be distorting policy. The more this bias is hard wired in through mandated targets, the more sub-optimal policy may become.

So, my own view at the moment is that I prefer the flexible dual mandate approach in the US to the explicit inflation targeting regime in the UK.[1] Now of course this view is predicated on US monetary policymakers being fairly close to the benevolent ideal. If instead policymakers without a mandated target acted as if they all they cared about was CPI inflation (as in the ECB, for example), the disadvantages of an inflation target fall away. Nevertheless, what my view implies is that – all other things equal – the case for a nominal GDP target relative to the current regime is rather stronger in the UK than it is in the US right now. 

[1] A possible half way house has recently been suggested by Kate Barker, who was a member of the MPC, This would be to target a range (say 1%-3%), where the point chosen within that range by the MPC would depend on other factors, like the output gap. 

Avoiding the B word

As I briefly listened to the radio the other morning, I heard the new head of the TUC (Trades Union Congress) talking about macroeconomic policy. She said the government’s policy of austerity has failed, and we need more investment in jobs. The interviewer asked whether this would mean more borrowing by the government. She avoided answering the question.

Unfortunately I have heard exactly the same from many UK public figures who are critical of austerity. It is as if a memo has gone round with the following instruction: whatever you do, do not say your alternative policy will involve more government borrowing. The writer of this memo presumably thinks that the general public believes additional borrowing is bad, and so it is best to avoid any admission that a policy might require it, even if this borrowing is temporary and at very low interest rates. Following Polly Toynbee, the paradox of thrift is too paradoxical for the public.

As some may have noticed, I have an unhealthy interest in macroeconomic spin. If you are concerned about policy you just cannot avoid it, and while it would be nice to pretend that spin does not matter, I suspect it would be a pretence. So, just on the level of spin, I cannot help feel that this fictional memo is ill conceived. Most people sense that when a public figure avoids answering a question, this is because they have something to hide. So in doing so, the effect is both to suggest that the policy will indeed require more borrowing, and that this is a problem, which is why the interviewee does not want to talk about it.

So here are a few alternatives, in the form of an imaginary interview

Q: Wouldn’t this involve the government borrowing more?

A: Yes, it would involve paying for the investment by borrowing. That is what a company would do if it saw a good investment opportunity, and we are always being told that the public sector should learn from good practice in the private sector.

Q: Wasn’t it excessive borrowing that got us into this mess?

A: Borrowing for a good reason is not a problem, as anyone with a mortgage will tell you. Borrowing becomes a problem when it underestimates the risks involved, and when the borrower may not be able to afford the repayments. The financial crisis was caused in part by excessive borrowing by consumers who thought house prices could never fall, but mainly it was banks over-extending themselves. The recession caused high government borrowing, and not the other way around.

Q: But isn’t pubic sector borrowing at record levels?

A: Yes, but so is the desire of the financial markets to buy public debt. This is why interest rates on public debt are so low. The financial markets desperately want to buy government debt, and so they are prepared to get very little back in return. That is one reason why now is just the right time for the government to borrow to invest.

Q: The government tells us that if it borrows more we will become like Greece.

A: This is nonsense. It is no coincidence that all the major countries experiencing a government debt crisis are in the Eurozone, because Eurozone countries do not have their own central bank. Governments outside the Eurozone have no problem borrowing at the moment – as I said interest rates outside the Eurozone are at record lows. If there was a serious risk that the UK would become like Greece, interest rates would not be so low.

Q: Isn’t it wrong for the government to be borrowing more when consumers are so strapped for cash, and often cannot borrow or are trying to rebuild their savings?

A: Exactly the opposite is true, as any economics student will tell you. If consumers are saving more, there is less spending power in the economy. If the government also spends less, we get a recession. That is the basic mistake the government is making. This is the other reason, besides low interest rates, why now is just the right time for the government to borrow more. In a recession, there is no danger that government spending will crowd out private spending, and it is much more likely to stimulate the economy.

Q: But surely no government can keep on borrowing more forever.

A: Of course not. But the right time to cut government borrowing is when the economy is strong, and the cost of borrowing is high.

Q: All politicians will find an excuse to spend more or tax less, and put off the day that borrowing is brought under control. At least this government has had the courage to deal with the problem, unlike their predecessors.

A: As many countries besides the UK are finding, it is much more difficult to bring down borrowing when the economy is weak. By contrast, many governments have succeeded in reducing borrowing when the economy has been stronger. Before the financial crisis, the ratio of government debt to GDP in the UK was below the level when Labour came into office in 1997. Bill Clinton successfully reduced US government debt during the 1990s, when the US economy was growing strongly.      

Q: But government borrowing more now will inevitably mean higher taxes in the future. We should not burden future generations in this way.

A: Not necessarily. By spending more today, we can reduce the need for the government to spend in the future, so taxes need not rise. As far as future generations are concerned, I suggest you ask some of the nearly one million young people who are currently trying to find a job what they think.

     

Macroeconomic Theory and the Multiplier

I agree with most of what John Quiggin says in his post on fiscal multipliers, but I started having problems towards the end when he writes:

“To sum up, despite the thousands of papers published every year in the field, macroeconomic theory is incapable of giving even a qualitative answer to the most basic questions about fiscal policy[3]; at least, not one that would not elicit dissent from a substantial, and well-credentialled group of leading experts.”

The footnote reads

“[3] While writing this, I wondered what would happen if you put this question to a group of DSGE theorists as a pop quiz. I suspect most would give some variant of “the question is ill-posed” and the rest would be all over the place. But, if any DSGE theorists are reading, I’d be keen to get their views.”

OK, I have written a fair number of published DSGE papers on fiscal policy over the last decade, so here is my response. New Keynesian theory, and therefore the New Neoclassical synthesis, provides pretty clear answers to the multiplier question. I have talked about this before so I will not repeat these answers here. Macroeconomic theory is ‘all over the place’ on many issues, but this is not one of them. I would go further. If policymakers had paid more attention to theory, and less to a well known piece of empirical work, they would have been less likely to have made the mistakes they have.

The problem is not ambivalent theory, but the fact that a large section of macroeconomists choose to ignore or discount the relevant theory. Now this is actually consistent with the sentence from John Quiggin’s post that I quote above, because of the part that says ‘at least ....’. So in that sense it is a quibble. But I think it is an important quibble. There is a great deal of difference between suggesting that theory is all over the place, and saying that a large body of theory – the theory used by nearly all monetary policymakers – is pretty clear, but that a significant group of economists do not accept it.

The difference comes in the following paragraph, where he says “It really is hard for me to see how the economics profession can recover from its current rotten state, at least as regards macro..” If a large section of the profession (perhaps even a majority) subscribes to the New Neoclassical synthesis framework, and that framework is sound (if far from perfect), then we still have a problem, but one that does have solutions.

Did Ricardian Equivalence kill the Pigou effect?

For macroeconomists

After the last time the world got into a liquidity trap, there was a debate about whether price flexibility would be sufficient to get us out of the trap. That debate tended to assume a fixed money supply. With that assumption, the answer today would be yes, if falling prices raised inflation expectations (given long run neutrality) and therefore reduced real interest rates. Back then that story was not so popular, perhaps because the debate pre-dated rational expectations. Instead the argument at the time focused on the Pigou or Real Balance effect. Falling prices raised the value of outside money, so everyone would feel wealthier and spend more.

We do not hear this argument so much nowadays. I have not seen this discussed in the advanced textbooks I know well (for example neither term is in the index of Romer or Obstfeld and Rogoff), so I was wondering why that was. Is the Pigou effect not what it was once thought to be? I could not find a clear answer to this question anywhere, but of course that may be my failing. So here are my thoughts, but they come with the possibility that I have just missed something. If I have, I will rewrite the post accordingly.

What I did find were a few papers that appeared to suggest that Ricardian Equivalence (REq) killed the Pigou effect. Here is a quote from a paper by Peter Ireland. After talking about REq, he writes

“Less widely appreciated, however, is a closely related finding, presented most explicitly by Weil (1991) but also implicit in earlier work by Sachs (1983) and Cohen (1985). These authors show that government-issued fiat money will not be perceived as a source of private-sector wealth if the households owning that money are the same households that, first, receive all of the transfers or pay all of the taxes associated with future changes in the money supply and that, second, incur all of the opportunity costs associated with carrying the money stock between all future periods. We are used to the idea of Ricardian Equivalence implying that government debt is not net wealth. Essentially consumers internalise the government’s budget constraint. But that argument applies to outside money as much as government debt. We can replace initial values of debt and money by the discounted future stream of primary surpluses they support.”

The easiest way to describe REq is that the infinitely lived representative consumer consolidates the government’s intertemporal budget constraint (IBC) into its own. Suppose this consumer owns some nominal (non-indexed) government debt, and the price level falls. Is that consumer better off? The real value of the future interest they receive on that debt will be higher, but this will be offset by the higher taxes in real terms that the government will raise to pay for this. The same argument applies to the higher real redemption value of the debt.

Ireland argues that exactly the same points can be made about outside money. Suppose money pays no interest, but consumers hold it because of the liquidity services it provides.

But if the consumer already has all the liquidity services they need (as they do in a liquidity trap), a fall in prices that creates more of this asset in real terms does not make the consumer better off on this account. So what about the redemption value of the additional real balances?

Here I’m inclined to think that money is different from government debt. In a paper[1] that I do not think has been published, Willem Buiter argues that money is irredeemable. The government only promises to redeem money with itself. So if I get a tax cut that is financed by printing money rather than issuing debt, there is no offsetting future tax liability. For this reason, money – unlike government debt – is net wealth for the consolidated public and private sectors.

Now a standard response is to say that a money financed tax cut does not make the consumer better off because the price level will rise, reducing the purchasing power of that money. It seems to me that is a different argument to REq – it requires going beyond just thinking about budget constraints. It is also an argument that does not apply to the Pigou effect, which is what happens if prices fall, raising the value of real balances.

Does the irredeemable nature of money rescue the Pigou effect from the REq argument? Yes and no. There is a crucial difference between Buiter’s analysis and the traditional view. In Buiter, it is the present discounted value of the terminal stock of base money that is net wealth for the consolidated private and public sectors, rather than its current value. To see why this matters, consider the liquidity trap case again.

As we have already noted, there is no liquidity trap in the flexible price case when the government holds the nominal stock of money constant, because falling prices today imply higher expected inflation. We do not need a Pigou effect. But the more interesting case, which I have talked about before, is where the government or central bank has an inflation target. In this case the authorities prevent inflation expectations rising, so real interest rates do not fall.

In that case nominal money will not be held constant when prices fall. Instead, the authorities will contract the nominal money stock in line with falling prices, to make sure inflation does not rise. As a result, there will be no increase in consumption, because the terminal value of nominal money falls, and its real value stays constant. Or, to put the same point another way, higher future taxes required to reduce the money stock will offset the wealth impact of higher current real money balances. There is no Pigou effect.

This is all terribly stylised and unrealistic, so there is no need to add comments that just point this out. However, I hope I’m not the only one who thinks this thought experiment is 
interesting. I also think that the proposition that inflation targets prevent macroeconomic ‘self-correction’ even when prices are flexible has a symbolic importance.

[1] Buiter, W.H. (2003) Helicopter Money: Irredeemable Fiat Money and the Liquidity Trap, NBER Working Paper No. 10163.