How to minimise the credibility damage of a rise in the inflation target

I had an interesting exchange with Malcolm Barr at JP Morgan via email.  He made two points that were food for thought.

Both are aimed at finding ways to minimise the risk that a rise in the inflation target was interpreted as an old-fashioned fiscal measure, or a losing of heart to control inflation as against other things that those pressuring policymakers are concerned about.

Recall that the real motive for raising the target is to improve macroeconomic stabilisation – including inflation control – by making sure the interest rate hits the zero bound less often.

The first comment was that ideally the inflation target rise would be done in a coordinated fashion, internationally.  Most developed countries settled on 2% before the crisis.  If all moved to 4%, say, at the same time, this would increase the chance of observers buying the economics behind it, and not concluding that the UK was just a basket case country.  It would also minimise the chance of an exchange rate adjustment when the inflation target was announced.

A second point Malcolm made was about whether compensation might be devised for holders of gilts who had bought expecting only 2% inflation.   So that there was no chance of inferring there was a direct fiscal benefit from an inflation surprise.

Thinking this through would be tricky.

There are also benefits to gilt holders to consider, like the reduction in inflation uncertainty coming from making room at the zero bound.  [Although from the perspective of investors the inflation target rise might increase uncertainty].  One option – appropriate if the bond market delivered faithful judgements – would be to let the price reaction to the news determine the net cost/benefit.  But that assumption is obviously somewhat heroic.

 

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14 Responses to How to minimise the credibility damage of a rise in the inflation target

  1. Roy Lonergan says:

    In addition to derisking the lower bound, wouldn’t a small amount of inflation just make everyone feel better? Nominal pay rises, bit more demand, animal spirits improve? Economists might live in the real world but the rest of us are in the nominal one.

    Roy

  2. >A second point Malcolm made was about whether compensation might be devised for holders of gilts who had bought expecting only 2% inflation.

    Is there currently compensation to borrowers when central banks miss their targets?

  3. mjbtlr says:

    A few points to consider:

    1) If raising the inflation target is seen as a valid policy response then how can you stop people from expecting it to be raised again in a future recession when we hit the lower bound.

    2) The decline in neutral real interest rates is a secular trend over many years so surely its better to address the route causes of this directly than to take the “easy” option and increase the inflation target.

    3) How could you realistically convince people that this is a one off.

    4) How can you expect people to take this seriously when central banks can’t even hit their current lower targets.

    • 1)
      That would be a benefit! We never want to hit the ZLB without expectation that something will be done to solve the problem.

      2)
      There may not be any way for central banks to raise the neutral real rate as it may be caused by real factors like demographics. It is quite possible that negative rates are the natural state for safe, short term stores of value.

      Before financial systems existed, almost all investments had negative returns if you didn’t put work and energy into them. To store value, you had to accumulate stuff, buildings or land. Most options either had high maintenance costs, were subject to risk of damage from natural causes and theft, were very volatile or required hard labor to get production out of.

      Even in societies with financial systems, getting risk free, hassle free, positive real returns has been difficult for most of history. This just reflects the natural laws of thermodynamics that tell us that everything tends to decay without a constant supply of work and energy. In general, most things require maintenance to keep their worth.

      The 20th century was probably the most notable exception. Because of unprecedented demographic and technological growth, positive risk free real returns were easy to find. The recency effect probably explains some of the confusion people have about this. It is possible that under favorable conditions, wealth can have positive returns and even compound into very good long run returns but it is not a guarantee and there is nothing natural about it. It may not continue forever amidst an aging and retiring population in a world no longer as rich in easy to exploit natural resources.

      3)
      Once we have a level of inflation that allows the economy to function, why would there be a need to raise it again?

      4)
      It might require some fiscal help but the higher target itself helps. If investors are convinced that the central bank won’t tighten prematurely in the future because they have better targets, they will invest more. This in itself pushes prices up.

  4. mjbtlr says:

    & Roy you do live in a real world as well even if you may not realise it. Imagine getting your pay rise and taking your friends out to dinner to celebrate but finding that the prices at your favourite curry house have gone up as well in response to the increase in the inflation target. Ultimately it is the real value of your wages that matters not the nominal amount because your standard of living depends on what you can buy with that money. I don’t think animal spirits would last long when everyone works out that their pay rise doesn’t go very far at the supermarket.

    • That is a very shortsighted way to see things. Unlike inflation caused by supply side constraints, central bank inflation happens mostly through the removal of barriers in the investment and jobs markets and by making business compete for workers. The competition for workers eventually leads to higher wages and then higher prices to pay for these wages.

      Since removing the monetary barriers grows real gdp, the average person ends up with more purchasing power on an after tax, after inflation basis (In this calculation you should also take into account the potentially better investment returns in people’s pension fund and the availability of better government services from higher government revenues without having to raise taxes, and the smaller part of the budget spent on providing unemployment and welfare benefits).

  5. Steve Williamson says:

    1. The credibility problem is important. Suppose we think that the actual inflation target doesn’t matter so much. Certainly the 2% target isn’t the product of careful science. So why not 4%, or 0%, or 5%? But we think that a credible commitment to some inflation rate is key. If people can expect x% forever, then the economy works more efficiently. Likely this has more to do with nominal intertemporal contracts than spot nominal contracts, but that’s another issue. So, start monkeying with the inflation target and you have a problem. Who says you’re not going to change your mind about it in another 3 years?
    2. If you are willing to bear the credibility costs of going to a higher inflation target, you must think that the benefits you get are sufficiently high. Where’s that come from? You must be assuming that something important has changed, and that things are going to stay this way for a very long time. I’m assuming you’re thinking some combination of low real rates of interest on government debt for a very long time, and higher dispersion in the underlying shocks. But, even if we buy that, we also have to buy the view that the benefits from stabilization policy are large. Presumably you think those benefits come from correcting relative price distortions by moving the nominal interest rate around. Do you really think those benefits are so large? Is hitting the ELB every once in a while really a big deal?
    3. If your concern is low real interest rates on government debt, maybe you should try to understand that better. Maybe accommodative central bank policies are just exacerbating that?
    4. A higher inflation target necessitates a nominal interest rate that is on average higher. That’s in your model. In my experience, people who want higher inflation targets also want lower nominal interest rates. Seems you can’t have both.

    • >I’m assuming you’re thinking some combination of low real rates of interest on government debt for a very long time, and higher dispersion in the underlying shocks.

      It’s low real returns on private safe stores of value that matter most.

      Economics has to tie into physical reality. If money has higher returns than stores of value with a physical manifestation tied to credible promises of future production then savings pile up as idle uninvested cash in bank accounts which is worthless to the aggregate. A rise in aggregate savings should lead to net new investment capital and new jobs not to rising idle cash.

      >Do you really think those benefits are so large? Is hitting the ELB every once in a while really a big deal?

      The careers of millennials’, of those living in rural regions or of any other economically disadvantaged groups have been scarred for life since 2008.

      Countless people lost opportunity to work and subsist in dignity because the funding for the tools and infrastructure that would allow them to have productive jobs has been blocked by central banks hitting the ZLB and failing to react forcefully enough.

      People lost access to education, to health care leading to tons of deaths. Desperation is leading to rising fascism in the western world. Before China also started monetarily shooting itself in the face, we were witnessing the western world losing its geopolitical influence. What more evidence do you want!

    • Tony Yates says:

      Thanks for these great comments.
      1. This is clearly a risk. The only defence is that the credibility issue cuts both ways. Suppose you were to believe plain-vanilla, non-neo-Fisherian NK macro. You’d expect inflation to be more controllable at a higher rate.
      2. You get me almost exactly right here. What’s changed is our estimation of the probability of hitting the zero lower bound. A bit more precisely, the integral of the sum of desired nominal rate trips below the ZLB. The crisis changed that. So even without buying all of Larry Summers’ argument about the future being about very low natural real rates, there’s a case to be made. With secular stagnation, there’s an argument for a temporarily higher target while low real rates prevail. It’s not just nominal price/wage distortions. eg credit frictions in DSGE models provide a motive too.
      3. What do you have in mind?
      4. I think you’re right that there are those people, but I’d just stick two fingers up at them and tell them they don’t understand.

      • Adam P says:

        Steve is Canadian, he only uses one finger for that (point 4).

        You stick two fingers up he thinks you mean “peace” or “victory” or something.

      • Tony Yates says:

        Thanks! Steve please take note.

      • Steve Williamson says:

        You have to be thinking that what CBs have been doing is adhering to an optimal policy, as dictated by an NK model, and that has led them to low, zero, or negative nominal interest rate settings. I’m not sure that’s true. And, getting away from NK, my chief worry is that going to low, zero, or negative nominal interest rate settings for extended periods of time is not something necessitated by economic fundamentals, but just driven by wrongheaded policy choices.

        On 3, some of this idea is in this paper:

        https://ideas.repec.org/a/eee/moneco/v73y2015icp70-92.html

        That is, model the reason why real interest rates are low – in this case a safe asset shortage. Basically, in the model, you have to account for the liquidity role of all assets, including currency and interest-bearing government debt. Then, you’re faced with a tradeoff, in that low interest rates imply less interest-bearing liquidity, and this tightens constraints. Implication: Given tight constraints the CB should be away for the ZLB. So, that goes the other way. Sticky prices say low real interest rates imply ZLB. Financial frictions say low real interest rates imply stay away from the ZLB. I’m working now with a sticky price model where the second effect dominates, in a wide array of circumstances.

        On 4, I’ve learned that sticking any fingers up can get you in some kind of trouble. Which finger(s)? Depends where you are.

      • Tony Yates says:

        I appreciate the point, now. A couple of thoughts. First, rates don’t have to have been following an optimal trajectory. In fact, part of the reason they might be low is that they are belatedly responding to overly tight policy before [not sure how historically accurate that thought experiment is, but..]. A Taylor rule or similar would do for an explanation. Second, I can think of two other financial friction examples which go ‘my’ way. DSGE models with either Kiyotaki-Moore or BGG inserted into them have the property that loosening policy eases the friction. [eg by boosting demand, improving net worth of banks, lowering equilibrium spread…]. Third, if you superimposed your story on an otherwise conventional NK model would the best thing to do not be business as usual [ie as per Woodford] with interest rates, plus Farmer like issuance of debt to buy risky stocks?

  6. Steve Williamson says:

    1. If “DSGE with K-M or BGG inserted” is a cashless model, then things may go as you say. But I think it’s important to actually include all the assets in the model. I’ve done plenty of messing around with these credit frictions, in models that are explicit about the assets, what they do, the CB balance sheet, etc., and I don’t get these effects.
    2. As for Farmer and purchases of risky assets, that’s venturing into territory where central banks should not go. The other day you mentioned that the ECB’s program of purchasing corporate debt would favor some euro area countries over other ones. So, you put your finger on the problem there, which is that central bankers are not elected officials, and once they make it obvious that their actions may be causing big redistributional effects, their independence is threatened. It may be the case that some, or all, of these asset purchase programs have negligible effects, but that’s certainly not the case the central bankers make when they use these tools. Even LSAPs involving long-maturity government debt gets into debt management – typically the province of the fiscal authority. We could decide that this is something that central banks should be doing, but CBs are asking for trouble if they step on the toes of other institutions.

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