A post from me on this topic that appeared on Ben Chu’s ‘Chunomics’ blog at the Independent.
Tony, if central banks are struggling to meet existing targets, why should we believe that they can meet a higher target?
It’s for when it’s achievable.
The tools are more important than the target. Heli’s dont have a ZLB and they avoid financial crisis by not lowering rates to stimulate.
Heli’s are identical to promises to keep future rates lower, theoretically. [This is gone through in Sargent’s textbooks, but also some of Woodford’s recent papers.
Practically, they entail great risks. Much greater, in my view, than a small increase in the inflation target.
The lower the inflation target, the harder it is to avoid undershooting it.
But you would never get a 4% inflation target past my mother, and the politicians know this. If the Conservatives announced a 4% inflation target, and Labour didn’t, she would even vote Labour. It is hard to explain why the inflation fallacy is a fallacy. I have to do it every year, to another crop of first-year students, but many still get it wrong on the exam. And I have a captive audience, who want to understand economics, with no hecklers.
You might have better luck with a 2% price level path target, which would also be less likely to hit the ZLB. Or a (say) 5% NGDP level-path target. (And if we did have an NGDP target, and were hitting it on average, then my mother would be right about inflation; the inflation fallacy would not be a fallacy, inflation really would make people poorer.)
I tweeted out the quote about your Mother, which was very nice.
I wondered if we could fly her over to sit through my lecture on the costs of hitting the ZLB?
Or, perhaps she’s already had several from you!
I do not think the idea is a kooky as some may think in the sense that they do address, indirectly, some of the key dynamics. A couple of issues though:
I think you may have missed the boat with a higher inflation target and am not sure how you are going to create the conditions for this. Perhaps 20 years ago was the time to stop the falling inflation paradigm..
Secondly I do not think the issue with the ZLB is to do with inflation but interest rates and the impact falling IRs have had on asset focussed money supply growth over a decade or more. Falling inflation has allowed IRs to move lower, partly in an attempt to stimulate growth and to respond to a succession of financial crisis/shocks to growth. Consequences have been ever higher levels of debt and asset prices, the ramifications of which were felt keenly in the latest of financial shocks (2007/2009)…
I think the major issue has been attempts to squeeze ever further growth from a structurally challenged frame. Whether people realise it or not interest policy has two major objectives: asset prices as well as economic activity support. There is much more to lower IRs than just inflation.
The ZLB issue is also an IR and asset focussed MS issue mixed in with secular stagnation issues at a fundamental level. For instance, what would have happened to Japan if instead of demographic headwinds it had had a population boom in the last 20 years. Inflation is there at the party but it is more of consequence than a cause.
Tony, I’ve been leaning towards thinking 4 or even 5% inflation target is sort of optimal, but I have some concerns about the costs of the implementation strategy. To shift up the inflation target, the central bank has to credibly commit to raising interest rates at some point, since the Fisher relation still seems to be a reasonable approximation in the long term. But my impression is that with the current monetary policy models there’s a lot of uncertainty about the policy path to do that. In a sticky price economy, the CB needs to first lower interest rates, or increase the length of low interest rates forward guidance, but then it has to eventually start raising interest rates. The question is when do you do the switch? Do you base your analysis on a model in which a low interest rate or forward guidance shock 1st raises inflation and then only when you see inflation above the new target start raising rates? But what if the low rates simply encourage people to discount the anouncement of the low inflation target, since our low rates period seems to be going on forever? And if you raise interest rates too early, the path to a higher inflation target could involve an accidental slowdown or recession.
I’m tempted to just reverse the graph on page 79, figure 8 in this BOC report,
But, the multiplicity of equilibria at the ZLB really complicates things.
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