Cecchetti and Schoenholtz on raising the inflation target

Mark Thoma sent round this interesting post from Cecchetti and Schoenholtz’s blog, [CS] asking whether 2% inflation targets were still appropriate.  In a nutshell, they argue that if central banks were starting over, they should pick a higher number.  But that the credibility risks of moving now are too great to make it worth it.

On this central point, 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.

If this is right, then it’s possible to imagine the legitimacy of the objectives of central banks being slowly questioned, and, once the consensus is eroded, central bank policy itself no longer being credible.  In the sense that no-one believes promises made for the future, because everyone can see that a switch in political government could easily lead to a switch in the central bank mandate.

Put more starkly, it may not even be sustainable to insist that inflation targets won’t be raised.  In the face of mounting evidence that this would be a way to avoid business cycle volatility and allow central banks to do their job with interest rates, a promise to keep inflation at 2 may not be believed.  It would become like the repeated promise of exchange rate targeters to kill off their traded sectors by sticking to an incredible nominal exchange rate target.

CS make an interesting point about the fact that the Reserve Bank of India has just chosen to target 4%.  This looks about right to them because of the fact that Balassa-Samuelson effects mean that as India catches up with the West, it will be on a transition path of naturally higher price level growth.  This coming about because faster manufacturing productivity growth leads to faster growth in the price of non-traded goods.

I thought I would tease this out a bit more.  In fact, this Indian catch up means there is nothing inevitable about faster growth of the overall price level.  It’s perfectly possible for India to choose 2% if it wanted.  Faster growth in non-traded goods prices would then simply be reflected in (probably) falling manufacturing prices.  The reason 4% is better for India is to avoid falling traded-goods prices there, on account of the inefficiencies that are aggravated if there is downward nominal rigidity in either goods prices or wages.  (I’m pretty sure Cecchetti appreciates this, recalling conversations with him a long time ago, but it’s not explicitly in the CS text.)

But, if you were persuaded by my arguments for why 2 per cent was too low for Western countries after the lessons learned from the crisis, you might be driven to thinking that 4% is too low for India.   Thinking rather roughly, one might add 2pp to a UK target to account for Balassa-Samuelson effects.  But a further increment to account for new knowledge about the size of potential financial-crisis-induced shocks, and the incompleteness with which other instruments can step in.

CS also point to another argument, that higher inflation tends to be more volatile.  I personally find that unpersuasive, at least as a decisive argument.  It’s circumstancial evidence against raising the target, but no more.  If the theory we have that tells us that inflation stability is a good thing is right, then actually, on account of the zero bound problem, slightly higher inflation should be more, not less stable.