Raise the banner! Oops, I mean the Inflation Target!

The higher IT idea has never died, and recently there has been a “great revival”. Cecchetti and Schoenholzt have a long post – Is 2% still the solution?” – but the conclusion comes on the third paragraph:

The debate over the appropriate level for a central bank’s inflation objective reminds us of a 40-year-old Sherlock Holmes movie called “The Seven-Per-Cent Solution.” Convinced that Holmes’ addiction to cocaine (the solution in the title) had made him delusional, Watson took the master sleuth to Vienna to be treated by Sigmund Freud.

Has the 2% solution for inflation targeting in advanced economies made central bankers similarly delusional? Are they stubbornly attached to an outdated target? That argument gained ground in recent years as policymakers in Europe, Japan, and the United States struggled to stimulate weak economies and stabilize prices with policy interest rates stuck at the zero bound.

Our view is that if policymakers could start from scratch, they might well choose a somewhat higher inflation target. Their rationale would be to avoid having to lower the policy rate to zero again in a future recession. But the cost of changing the policy framework now would be a substantial loss of credibility, so there seems little chance for a new regime with a higher inflation target.

Tony Yates, who has been pushing the “raise the banner” idea lately, comments on C&S:

On this central point [the credibility issue], I don’t think we can know.  This is the sort of thing central bankers and ex-central bankers [Steve being one!] say a lot.  But there isn’t any good theory or empirics of reputation formation and dissolution, so we are in the dark.  I remember thinking it rather wishful thinking that inflation targeting – simply promising to create the amount of inflation you wanted – would be believed, especially after a few decades of failed proper [read ‘intermediate’, ie exchange rate/monetary] targeting.

I would also like to re-emphasize a point I made in my earlier post, that worrying about credibility is the right thing to do, but might cause us to be concerned about the status quo.  If unconventional monetary policies are not as effective, or more costly to wield than interest rate policy, and if there are insurmountable political obstacles to using discretionary fiscal policy, then too-low inflation means more busts than we thought.  And a higher risk of being trapped forever at the zero bound.

Krugman, one who has never let go of the higher inflation target idea, comments on a very interesting series of posts by Mathew C. Klein on the 2009 FOMC Transcripts:

Matthew Klein has been going through Fed transcripts from 2009, and notes that the Fed was surprised at the persistence of inflation despite the Great Recession. Oddly, however, he seems to suggest that this episode weakens the case I and others have been making for a higher inflation target. Actually, it strengthens that case.

And concludes:

So the failure of inflation to fall as much as predicted in 2009 was part of a series of events that were trying to tell us that the initial inflation target was too low.

I think the “higher IT” debate is a complete waste of time and effort. Over many years, even decades in some cases, inflation was kept low and stable, both for countries formally targeting inflation, either point targeting at 2% or targeting within a narrow band centered at 2%, and for countries, like the US, who had no numerical target, just a concept of what “price stability” meant (according to Greenspan, it was a rate of inflation that didn´t affect people´s plans).

My conjecture is the “good times”, or “Great Moderation” experienced by many countries, many times beginning in the mid-1980s and extending to 2006-07, has mistakenly been credited to IT, even if it was, like in the US, only informal (or implicit). What was really behind the “good times” was the accomplishment, by many central banks, of nominal stability, a much more encompassing concept.

In fact, the IT idea emerged, “out of the blue”, in the late 1980s, when the New Zealand government was seeking to improve general government performance and began giving departments and agencies clear goals by which they could be appraised.  I can just imagine what went on in the head of the RBNZ Governor when asked how he should be evaluated. Seeing that inflation was falling after being in the two-digit range for many years, his quick answer must have been something like “keep inflation low”. Thus was born IT!

That doesn´t give IT a good “pedigree”. Nevertheless, academics were quick to develop theoretical and model-based frameworks that gave IT the “pedigree” it needed to flourish. So why is it that at present there´s so much discussion on “regime change”?

Great minds predicted this. More than a decade before IT “emerged”, Nobel Laureate James Meade in his 1977 Nobel Lecture called IT dangerous:

Earlier I spoke of ‘price stability’ as being one of the components of ‘internal balance’. Yet in the outline which I have just given of a possible distribution of responsibilities no one is directly responsible for price stability. To make price stability itself the objective of demand management would be very dangerous. If there were an upward pressure on prices because the prices of imports had risen or because indirect taxes had been raised, the maintenance of price stability would require an offsetting absolute reduction in domestic money wage costs; and who knows what levels of depression and unemployment it might be necessary consciously to engineer in order to achieve such a result? This particular danger might be avoided by choice of a price index for stabilisation which excluded both indirect taxes and the price of imports; but even so, the stabilisation of such a price index would be very dangerous. If any remodelled wage-fixing arrangements were not working perfectly, – and it would be foolhardy to assume a perfect performance – a very moderate excessive upward pressure on money wage rates and so on costs might cause a very great reduction in output and employment if there were no rise in selling prices so that the whole of the impact of the increased money costs was taken on profit margins. If, however, it was total money incomes which were stabilized, a much more moderate decline in employment combined with a moderate rise in prices would serve to maintain the uninflated total of money incomes.

Flash forward thirty years to 2007 and the “danger” materializes under Bernanke Chairmanship of the Fed. And this mostly happens because Bernanke was known as an ardent defender of inflation targeting and would likely act accordingly.

Later in the Lecture Meade proposes NGDP Level Targeting

I have told this particular story simply to make the point that the choice between fiscal action and monetary action must often depend upon basic policy issues which should certainly be the responsibility of the government rather than of any independent monetary authority. Perhaps the best compromise is an independent monetary authority charged so to manage the money supply and the market rate of interest as to maintain the growth of total money income on its 5-per-cent-per-annum target path, after taking into account whatever fiscal policies the government may adopt. One would hope, of course, that there would be a suitable discussion of their plans and policies between the government and the monetary authority; but the latter would be given an ultimately independent duty and independent choice of monetary policy for keeping total money incomes on their target path.

Among the suggested “new regimes”, NGDP Level Targeting stands out. Why so much interest in NGDP Level Targeting?

To me, one important, maybe even defining, reason is that over the whole of the pre 2008-09 crisis “inflation targeting period”, including all the non-IT central banks, like the Federal Reserve, that nevertheless managed to keep inflation low and stable, all the “targets” (NGDP-LT, IT and PLT) were observationally equivalent.

To illustrate I look at Canada, an inflation targeter and the US, which did not target anything explicitly.

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For both countries before the crisis, NGDP growth trend is 5.4% while both Headline and Core inflation are approximately 2% in the two countries.

Note that up to the moment the crisis hit, you wouldn´t be wrong to think, if you didn’t know otherwise, that both countries could be doing either IT, PLT or NGDP-LT. There´s no way to distinguish among the alternatives.

What the crisis showed is that inflation or price level targets are not robust, or dependable, “target rules”. If an NGDP-LT target had been explicitly pursued, both the Fed and the Bank of Canada (and many other central banks) would have heard the “dog bark” loud and clear! (Note that the IT and PLT “dogs” “barked up the wrong tree”!)

In fact, inflation targeting is not something that naturally defines central bank procedures. If you contrast New Zealand and Australia, for example, you´ll learn that macroeconomic outcomes other than inflation can be widely different even for inflation targeting central banks.

This adds to Ball and Sheridan´s findings in their 2003 article “Does Inflation Targeting Matter?” that since the early 1990s inflation has been lower and more stable in both IT and non-IT countries.

Ball and Sheridan´s findings are consistent with the idea of observational equivalence between IT, PLT and NGDP-LT that I illustrated using Canada and the U.S. From this, one could infer that low and stable inflation countries followed a de facto NGDP-LT targeting. The crisis had the effect of revealing the actual targeting regime.

A country such as Australia, where NGDP remained close to trend is more likely to have been following a NGDP-LT targeting regime than Canada or the U.S., where NGDP dropped well below trend.

Another inflation targeting country that the crisis revealed was de facto targeting NGDP is Israel. The contrast between Israel and the U.S. clearly brings out the danger of IT alluded to by James Meade. Although the U.S. was not formally an IT country, when Bernanke took the helm at the Fed in early 2006, it got much closer to being an IT country.

The different reaction of each Central Bank to the oil shock explains the different outcomes. While an oil shock (a negative supply shock) increases inflation and reduces growth, those effects tend to be temporary and the best monetary policy can do is to keep nominal spending close to trend. The charts show that by doing exactly that Israel avoided the real output contraction that befell the US and other de facto IT countries.

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The German-centric ECB is arguably the most ardent IT central bank. For market monetarists, who strongly favor NGDP-LT, it is not surprising to observe the dramatic results, with the region going into deflation and real growth being close to zero and negative for some individual countries.

The chart below removes any doubt one may have on the dangers of inflation targeting in the face of supply shocks.

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In the chart we observe the dramatic consequences of the ECB tightening in reaction to the rise in oil prices in 2008 and again in 2011.

Given the evidence I find Carl Walsh´s conclusion in his 2009 paper “Inflation Targeting: What Have we Learned?” depressing. To Walsh:

Financial meltdowns, such as the United States is experiencing at the time this is written, pose similar problems for IT and non-IT central banks. In that sense, they are irrelevant for the inflation targeting debate…

They certainly are not irrelevant. Countries, be them inflation targeters or not, that were on a de facto NGDP-LT regime fared much better than the de facto inflation targeters. And the reason is straightforward. NGDP-LT provides a much higher degree of nominal stability to the economy, and thus is much more effective in limiting the propagation of real shocks.

Therefore, instead of “suggesting” a higher target inflation, economists should try to help central banks “rediscover” nominal stability. For that, finding the appropriate level of nominal spending is required. It is not enough to just keep nominal spending growing at a stable rate, as the US has mostly done since emerging from the crisis.

PS An expanded version of this post can be found in “Which is more reliable” (PDF)

One thought on “Raise the banner! Oops, I mean the Inflation Target!

  1. Excellent blogging. Yes, NGDPLT is best. But perhaps a close second is RBA’s IT band. As you point out, they have done well with the band, perhaps as it allows a large degree of de facto NGDPLT.
    Do central banks need better real-time data collection to effect NGDPLT?

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