Kocherlakota and the credibility calculus of raising the inflation target

Krugman, Blanchard and others have suggested raising the inflation target as a way to prevent – or at least reduce the severity of – future episodes where the monetary policy interest rate is trapped at zero.

This is a position I have supported as a measure not to help alleviate current difficulties, but as something to consider once the current target is demonstrably met.

On Twitter last night, commenting on Stanley Fischer’s contribution to a panel at the American Economic Association meetings in San Francisco, outgoing FOMC member Kocherlakota expressed his scepticism about the wisdom of raising the inflation target.

Quite rightly, he pointed out that doing this might raise the probability that observers would put on a further inflation target rise sometime in the future.  This would be a bad thing because of the resources consumed as people try to insure against the implied inflation uncertainty, and because it raises the real costs of delivering inflation on target.

However, credibility worriers also need to remember [and here I don’t finger Prof Kocherlakota for failing to] that in some respects raising the inflation target may improve the credibility of monetary policy and reduce inflation uncertainty.

By persisting with the current 2 per cent target, the Fed and other central banks risk further long episodes at the zero bound, and further protracted periods in which inflation is substantially below target [in the UK headline inflation has been about 0 for a year now], and corresponding uncertainty about whether the central bank can ever regain control over inflation.  If setting a higher target means reduced time at the zero bound, then it most surely means better inflation control, and enhanced ‘credibility’, in the sense of the reputation for competence and inflation forecasts that would follow from inflation turning out to be closer to the new, higher objective.

Prof Kocherlakota commented that the Fed’s performance in returning inflation to target during this zero bound episode will inform the expectations that observers form when the next episode ensues.

True enough.  If inflation is returned to target, finally, this ought at least to demonstrate that what was possible this time may be possible in the future, and that reaching the zero bound does not mean automatically becoming like Japan and getting oneself trapped there for 2 decades.

However, this episode will nonetheless underscore the chances of another one of several years, during which it may be forecast that there is a lot of time for further crises to entirely derail monetary policy.

Moreover, expectations will also be informed by the knowledge that the central bank won’t have the advantage of a 5 percentage point cut introductory stimulus [the resting point for rates in the future will be more like 2-3%].  And that there will be less fiscal space, and probably also less political appetite for helping hand from fiscal policy.   And also, should the zero bound be revisited in the next several years, that central bank balance sheets will start out swollen, and so may be expected not to afford the possibility of equally large unconventional monetary policy measures.

 

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