Raising the inflation target: great idea, but not now.

In a recent paper, Paul Krugman, echoing a suggestion made by Olivier Blanchard, makes a compelling case for raising the inflation target in the US and other Western economies, to avoid the difficulties that would come with another episode at the zero lower bound [ZLB] to interest rates.  I wholeheartedly agree, but now is not the time.

Why not?  Although core inflation in the US shows signs of rising, the Fed has not decisively won the battle to stave off risks of deflation.  And raising the target now would set them up to fail.  Right now the Fed needs a chance to regain its reputation for being able to deliver on-target positive inflation.

Moreover, a rise in the inflation target now would mean another further protracted period where interest rates were held at the zero lower bound in order to send inflation higher [before rates eventually settled at the higher level that the Fisher equation would suggest would be associated with the higher inflation target].   What worries me about this is that such an economy would begin to look to a sceptical econometrician like one in a permanent liquidity trap, risking a fall in inflation expectations that would make such a conclusion self-fulfilling.

Given the current balance of power in Congress, and the likely waning of the Obama Presidency as it heads into its final 18 months of office, raising the inflation target – if not achieving anything new of note in economic policy – would seem to be completely infeasible anyway.  And attempting it would risk reopening other discussions about the Fed’s monetary policy and other objectives that could end up leaving the Fed with a less well designed set of tools and objectives than currently.

In the UK, raising the inflation target can be achieved by George Osborne writing a short letter to Mark Carney.  (Another example of the curious tendency in UK constitutional life for important facets of the political economy to be sustained by durable but seemingly fragile convention.)  Should George write one now before the next Mansion House speech?

In the UK inflation never looked like falling below the inflation target, and instead was for many years greatly above it.  So risk of setting up the BoE for a failed attempt at creating more inflation is less.  However, interest rates have been pressed at the zero bound since December 2009 and are expected by most to remain so until at least the beginning of 2015.  A further protracted period of apparently constrained monetary policy may indeed wind up failing, or looking like failure.

In the UK, reputational concerns work the other way, but would perhaps still mitigate for raising the target much further down the road.  Raising it now would look like consolidating into the objectives the above target inflation outcomes of the last seven years or so.  [‘Aha, this is what they were doing all along, and only now do they come clean about it’].  I take the view that the above target inflation was a brave, wise and deliberate overshoot, a price worth paying for temporarily higher output and lower unemployment [even if the BoE’s MPC did not always describe it in this way].  However, a sold period of being shown to achieve inflation around 2 per cent, instead of inflation around 5-6 per cent, would make a subsequent target hike look more like a considered policy change, and less Machiavellian.

If such a raise were contemplated, I would counsel that it should be accompanied by changes in the statutory framework for the BoE that would do away with the power to change the target by the mere writing of a letter, to allay suspicions that the political authorities would acquire a taste for writing more of them.  This surprising piece of discretion is anyway an anachronism, associated with the understandable trepidation that New Labour felt in 1997 at handing over responsibility for monetary policy to the Bank of England.  It hasn’t turned out so badly as Ed Balls, then Gordon Brown’s advisor, and presumed architect of the current system, must have feared.  And anyway, it is surely enough that the Treasury make most of the  appointments to the Monetary Policy Committee, and retain emergency powers to take back control over interest rates.

What about the Eurozone?  The ECB devised its own objectives and has the power to revise them.  Provided they can be interpreted as achieving the vague ‘price stability’ mandate that constrains it.  There the case for an inflation target rise to make more room above the ZLB is even more compelling, since the difficulties of coordinating substitute stimulus policies (conventional tax and spend policies, or quantitative easing) are, as we have been watching, much greater.  However, the timing would be even worse, with the ECB already struggling to get EZ inflation even close to its inflation target.

And the political chances of such a venture must be considered almost nil.  It would require persuading the Germans, whose cooperation is already stretched to its inadequate limits.  The Germans also operate under their own price stability constitution clause, actively policed by its judiciary.   It’s conceivable that a higher inflation target could be legally defended as, somewhat perversely, preserving ‘price stability’.  If the result of a higher target was to eliminate the chance of becoming trapped at the zero bound, inducing intractable deflation, or perhaps losing control of the price level altogether, then higher inflation might mean more stable prices.  It could certainly be interpreted to be a measure to generate more price controllability and predictability.  But though such a legal strategy seems conceivable, it seems highly unlikely to succeed.

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4 Responses to Raising the inflation target: great idea, but not now.

  1. Anon says:

    If the Fed were to increase its inflation target, it could do so without any explicit action from Congress or the executive branch (not even a letter from Jack Lew). The 1977 amendment to the Federal Reserve Bank is parametrically nonspecific about the inflation component of the dual mandate.

    • Tony Yates says:

      Thanks, yes. I was puzzled why you made this remark, until I read the draft back again and I can see that the emphasis on the letter writing and the comment about Congress misleads. The way I used to see the Fed-Congress relationship was that, e.g., even announcing a formal inflation target, or changing it would prompt Congress to intervene to try to stop it with efforts to supplant or revise legislation governing its activities. A few Fed officials that I spoke to during my BoE days held the view that this was one reason a formal inflation target had been eschewed.

      • Anon says:

        The concern those Fed officials expressed to you didn’t seem to have much predictive content. That is, when it announced in January 2012 that it had adopted a 2% long-run inflation target (independently of Congress & the White House & Co), the political reaction was pretty much zilch.

        A scenario in which Congress intervenes as per your description IMO is highly unlikely. Consider, for example, the intense rabble-rousing in the wake of the Volcker disinflation. The part of the protests that came from official Washington (including the White House) was arguably more intense than what occurred in the post-AIG, etc. period; see, e.g.,


        While Volcker was not renominated for a third term in 1987, Congress, etc. took no legislative action to constrain the Fed.

      • Tony Yates says:

        A very small sample! The fact that the Fed’s strategy clarified 20 years after BoE/BoC/RBNZ,RBA had something to do with the worries about provoking just such a reaction, I would conjecture, and that is consistent with what I was told by many. And it would be one thing clarifying a strategy of desiring 2 per cent. Another changing it to 4 or 5 per cent.

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