The new “one size fits all”: 4%

For the last four years many have touted increasing the inflation target to 4% as the best way to “cure” our ills. If I well recall, it started with the IMF, at least by its Chief-Economist Olivier Blanchard, who in an IMF publication wrote “Rethinking Macroeconomic Policy”:

The crisis has shown that large adverse shocks can and do happen. In this crisis, they came from the financial sector, but they could come from elsewhere in the future—the effects of a pandemic on tourism and trade or the effects of a major terrorist attack on a large economic center. Should policymakers therefore aim for a higher target inflation rate in normal times, in order to increase the room for monetary policy to react to such shocks? To be concrete, are the net costs of inflation much higher at, say, 4 percent than at 2 percent, the current target range? Is it more difficult to anchor expectations at 4 percent than at 2 percent?

This was followed by a piece in VoxEu written by an IMF researcher arguing that a 4% inflation target would have done wonders for Japan:

Olivier Blanchard, the IMF’s Chief Economist, recently broached the idea that central banks should target an inflation rate of 4% during the good times to leave more room for nominal rate cutting during bad times. This column supports this view, presenting new research showing that a higher inflation target could have halved the output loss of Japan during its “Lost Decade.”

Obviously Krugman had to revive his 1998 “credibly promise to be irresponsible”:

The basic point is that a higher baseline for inflation would make liquidity traps, in which conventional monetary policy is up against the zero lower bound, less likely and less costly when they happen.

Later, Laurence Ball ‘confirmed’ the ‘magical properties’ of a 4% target for inflation in “THE CASE FOR FOUR PERCENT INFLATION“:

Many central banks target an inflation rate near two percent. This essay argues that policymakers would do better to target four percent inflation. A four percent target would ease the constraints on monetary policy arising from the zero bound on interest rates, with the result that economic downturns would be less severe. This benefit would come at minimal cost, because four percent inflation does not harm an economy significantly.

Krugman completely agrees with Ball:

The point is that the conventional 2 percent target is a prejudice, nothing more; it once rested to some extent on studies suggesting that 2 percent was enough to make the zero lower bound a non-problem, but we now know how utterly wrong that view was; so we’re left with a target that’s considered respectable because it’s what all the respectable people say, and is what all the respectable people say because it’s considered respectable.

What do we want? Four percent! When do we want it? Now!

And just now (yesterday) Krugman berates the IMF for not saying it clearly:

(IMF) With respect to monetary policy, a period of continued low real interest rates could mean that the neutral policy rate will be lower than it was in the 1990s or the early 2000s. It could also increase the probability that the nominal interest rate will hit the zero lower bound in the event of adverse shocks to demand with inflation targets of about 2 percent. This, in turn, could have implications for the appropriate monetary policy framework.

(PK) What does that actually say? Well, my subtitled version says this: Raise the inflation target to 4 percent, dummies. But the IMF wouldn’t, and presumably can’t, say that outright. And I suspect that the people who need to hear that won’t at all get what the Fund is really saying.

But four years earlier the IMF had said it!

What does experience and the above arguments for increasing the inflation target really tell us?

Look at inflation as a virus which has to be treated. The prescribed medicine was “IT” (@2%). But when the virus is “killed” you stop taking the medicine and adopt other means to stay healthy. You exercise regularly; you eat healthy food, don´t drink too much or practice chain smoking.

Likewise, when inflation has been “tamed” you need to adopt a different monetary policy framework, not just increase the target. Those who suffered from the previous virus inflation infection will be quite skeptical of substituting the “virus” for a less infectious “viroid” [an infectious particle smaller than any of the known viruses].

Most (maybe all) countries that suffered (in different degrees) from the inflation virus and adopted an “IT” framework (explicitly or implicitly) were successful in curing the disease.

But low inflation (and low expected inflation) goes together with low nominal interest rates. So the argument for a higher inflation target is an argument for higher nominal interest rates. And the only reason for that is to avoid another instance of the ZLB.

That reasoning flows from the view that monetary policy is interest rate policy that´s used to control aggregate demand and therefore the output gap. Oh! If only that were more or less precisely observed…

But if you change your approach and view monetary policy´s major function as providing nominal stability, analogous to keeping the whole economic fabric healthy and so avoid both bouts of “infection” and the ZLB, you will naturally decide to target the most encompassing nominal aggregate. Guess which one that is!