On raising the inflation target to combat secular stagnation

Tim Harford’s FT article responds to the recent ebook on secular stagnation – the tendency for weak demand to depress equilibrium real interest rates – circulated by VoxEU.  He deduces that raising the inflation target would help combat or avoid it.

Well – at least through the lens of modern macro – yes and no.  First, raising the inflation target now might well not help at all.  With the reliable and conventional tool of interest rates at their zero floor, and fiscal room for stimulus argued by some to be minimal, or at least politically limited by those with this view, there would be no means to achieve a higher inflation target.  At least, if you are sceptical that QE has any great effect beyond signalling the future path of central bank rates.  [A view held by Barro, Sims, Woodford, Cochrane and many others, though one that is controversial.]  If this was the case, raising the inflation target could be self-defeating, since it would set up the central bank to fail, and the credibility of monetary and other public macroeconomic policies could suffer as a result.

In this sense, raising the inflation target is something we should consider as a step to take to reduce the probability of interest rates having to hit the zero bound again in the future, ie as a preventative measure, rather than a cure for future ills.

Note too that as a preventative measure it won’t entirely eliminate the bad consequences of secular stagnation.  In the long run monetary policy can’t do this.  As Tim notes in his post, low equilibrium real rates are ultimately determined by supply and demand.  Higher inflation will lead to longer time higher levels of the central bank rate, making more room for larger interest rate cuts, and, repeat, making it less likely that policy gets trapped again at the ZLB and the real side of the economy suffers from the recessionary traps associated with being stuck there.  But long run higher inflation won’t – a few minor details glossed over – do anything to raise long term growth or equilibrium real rates.

So, in sum, higher inflation isn’t a good cure for today’s ills, and would only be a partial solution to the unattractive features of longer run secular stagnation.  I’m personally in favour of raising the target at some point.  Indeed, as I blogged before, I’ve urged that we consider setting up a body to conduct low-frequency reviews of the appropriate inflation target, to respond to low-frequency changes in real rates.  But not now.  And we shouldn’t hope for too much for it, and not lightly dismiss the costs associated with it in potentially unhinging expectations of nominal stability.

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4 Responses to On raising the inflation target to combat secular stagnation

  1. There is confusion about cause and effect, here and elsewhere.

    The economy is not suffering or malfunctioning, it is behaving properly (attempting) to properly price risk, this risk is shifted over to interest rates. The participants in the markets are malfunctioning but not surprising as most of them are thieves and the rest are wannabes.

    The problem has nothing to do with rates (cost of money) but rather cost of capital (not money, but rather non-renewable natural resources including waste-carrying capacity). Because money is nothing more than a claim against purchasing power (which declines obviously along with the resources that are being purchased). Reducing money costs accomplishes exactly nothing because claims are either diluted or redundant, that is, more money does not equal more purchasing power.

    Interest rates have some affect on the finance system through-puts and its ability to distribute finance system losses but that has nothing to do with the structural defects within the economies that cause purchasing power to evaporate.

    The only (economic) solution is stringent energy- and resource conservation. Otherwise: ‘Conservation by Other Means ™’. You don’t want to know what those other means are …

  2. Pingback: FocusEconomics Blog

  3. Thaomas says:

    The proposal of a higher inflation target has nothing to do with secular stagnation (in the proper, supply side, TFP sense). The point is that it makes it less likely that we will fall into an AD deficient recession. Of course if the Fed had an inflation target and not an inflation ceiling and acted consistently to achieve it perhaps a higher target would not be necessary, Alteernatively, the Fed could set an NGDP level target.

    • Tony Yates says:

      Yes it does. There are broadly two versions of the thesis. One emphasises a slow down in the rate of improvement of technology. The other, emphasised by Larry Summers, explains a set of reasons why the natural real rate of interest is very low, and, hence, the average central bank is very low, and will continue to be. That in turn means more frequent visits to the zero bound and inadequate stimulus from monetary policy. That demand-side SS can be alleviated by targeting a higher inflation rate. If you believe in highly forward-looking expectations, levels targets [PL or NGDP] can help, but not entirely overcome the problem of the ZLB. These conclusions follow from the standard monetary sticky price model developed by Woodford and others and used in all central banks today.

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