Brad Delong and Isabella Kaminska are against raising the inflation target as a response to secular stagnation. To recap. Larry Summers argued that currently the natural real rate is very low and may remain so for quite some time ahead. Other things equal, this is going to generate a low value for the nominal central bank interest rate required to hit a given inflation target. This leaves less room for rates to respond to further contractionary shocks, since starting out at this already low nominal interest rate ‘steady state’ [if that is the right word for it] means the ZLB is not far away. To make more room, to raise the low-frequency nominal interest rate, central banks or their finance ministry bosses could temporarily – or, as Blanchard suggested before, permanently – raise inflation targets. Delong emphasises the corrosion of credibility that would result. Kaminska suggests that it could prompt a flight from state, fiat stores of value.
A few quick points in favour of increasing inflation targets.
First, fighting to preserve the credibility of a policy can be counter-productive. If raising the inflation target is workable [suppose we put aside currency reform to eliminate the zero bound for a moment, something Miles Kimball has been pushing lately], the authorities will lose legitimacy if they don’t opt for it. Sooner or later there will arise the view that a political consensus will form for raising the inflation target, and this will feed into expectations, come what may. Failing to choose what’s sensible could also undermine the credibility of other policy tools too. If you can’t trust the authorities to do the right thing with monetary policy, the punter on the street may muse, why should we continue to allow them independence to supervise banks [or do anything else]? If you buy Martin Wolf’s view that the authorities’ legitimacy to govern is already strained, this is the kind of straw that could break the political economy camel’s back. As an analogy, [and repeating points from earlier posts] I don’t think UK fiscal credibility would have been served by Osborne doing what he said he would do at the outset, sticking to the Coalition’s austerian Plan A consolidation. Having made the initial error of making the unkeepable promise, he did the right thing and reneged, at least twice. Had he not done so, he would have brought the Coalition’s legitimacy to govern into total disrepute. Likewise, if raising the inflation target is the right thing to so, the long term reputation for competence will be best served by doing it. If.
Second, Kaminska and Delong, in my view, over-play the worry about stores of value. I would observe that past history suggests that it takes serious departures from price stability – hyperinflations, or sustained bouts of very high inflation – to dislodge an equilibrium where agents coordinate on using the state’s chosen fiat currency. Examples: the Jacobins’ debasement of the Assignat, vouchers presentable at auctions of confiscated church lands. The adoption of the Undidad de Fomento in Chile after hyperinflation there, documented by Robert Shiller. Dollarization elsewhere in Latin America. A logical, pre-announced, moderate increase in the inflation target, unconnected with public finance needs [perhaps accompanied by a further switch into financing using indexed debt], need not undermine the collective choice to use state fiat currency.
Two parting side points. First, note that Michael Woodford shows [in his textbook Interest and Prices for example] that you don’t need the fiat currency to be the chosen store of value for monetary policy to have traction. What you need is that this currency still defines the unit of account. Second, foregoing seigniorage by encouraging a further shift out of money would not be material for public finances, since it currently accounts for only a tiny fraction of revenues.