Re-specifying the inflation target for low real interest rates

The Fed’s John Williams has commented that the Fed should revisit the inflation target to provide for future episodes in which very low interest rates are needed.

This is welcome.  Blanchard, Krugman, and many others have made the same argument.

A higher target would lead to the resting point for central bank rates rising one for one, roughly, [risk premium calculations aside] making more room for interest rate cuts when the Fed next has to deal with a recession.

QE and conventional fiscal tools can substitute for monetary policy at the zero bound, but the former is less trusted by most and the latter can’t be counted on to be wielded swiftly or with the same technocratic aim as tools used by the independent central bank.

Unless you are a neo-Fisherian – those who think that current low rates are the cause, not the right response to, low inflation – or think that the costs of moderate inflation are very acute, you will be in favour of a higher target.

However, an awkwardness is a Fed official himself arguing for a change in the Fed’s goalposts.  Central bank independence useful because it removes politics from monetary policy.  But it creates a principle-agent problem.  We might worry that the central bank uses its powers for its own political purposes, or those of its friends in the financial sector, or who knows what.

So the Fed – the agent – setting its own target on behalf of its principal [Congress] is not ideal.  On the face of it this invites cynics to guess that the Fed will choose the target to suit itself.  For the case in hand, raising the inflation target might confirm the suspicions of the permahawks who thought QE and low rates was a terrible liberal conspiracy all along.  Or seem like a matter of expediency as the Fed tries to turn rising inflation from a problem into a target.

In the UK there is a clear system whereby the BoE has independence over instrument settings, but the goal is set by the Treasury, so the problem does not arise.  Though of course we have to hope that the Treasury has the expertise and the political support to do what’s right.

In the US, politicians did set the original dual mandate for the Fed, but the monetary part of this  was written vaguely in terms of ‘price stability’.  The current 2 per cent target was a Fed initiative, moved towards at first without explicit quantification, and slowly.  This cautious adoption of inflation targeting was no doubt in part because it was feared that politicians would judge that the Fed had exceeded its powers in refining/changing its remit and/or that this would fuel efforts to reopen more basic discussions about what the Fed should be doing, and set them on one of the crazier paths that some political factions favour.  Williams opening the discussion of raising the target runs the same risks.

An added complication is the Trump administration.  Trump not so long ago accused Yellen of setting monetary policy to suit the Clinton campaign.   A call for higher inflation feels unsettling in this context.  And it comes as Neel Kashkari, who felt he had soon dealt with the ‘Too big to Fail Problem’ by calling for higher capital requirements, has been treading the boards setting up an ‘Institute’ for studying ‘Inequality’ and calling for a transformation of education.

Although the technical arguments for a higher target are very clear, I think you can make a good case for foregoing these benefits in the US, relying on unconventional policy, until such time as you don’t have to worry about uniting Trump and moderate Republicans around the meme that the Fed is a holdover liberal cabal from the Obama presidency.

 

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3 Responses to Re-specifying the inflation target for low real interest rates

  1. Biagio Bossone says:

    Tony,
    even assuming central banks would re-specify the inflation targets, how would that work in practice? Since the crisis, central banks have in fact tried to raise inflation through a host of unconventional policies and yet they have not even succeeded to achieve their (moderate) inflation targets. How could they ever achieve even more ambitious inflation targets? With what instruments? If they have not the instruments, wouldn’t re-specify inflation targets put their credibility further more at risk? Only two things central banks have not yet tried: helicopter money and Neo-Fisherian interest rate policy. But they seem to not like either approach. What else, then? Would simply an announcement of a higher inflation target work?

    • Tony Yates says:

      Raising the target is for when inflation has demonstrably been brought under control again, which means having hit the current target for a sustained period of time. I think that in the US, UK and EU we are starting to see that happen. Done too soon it would beg the questions you raise. I mentioned this in some of my previous posts on the issue.

  2. salmo trutta says:

    You only have to re-load when you miss. I could shoot better than Jed, Jethro, and Elly c. July 1979. Contrary to 2 qtr., Bankrupt u Bernanke, it’s impossible to miss within one year’s period. The money stock (& DFI credit, where: loans + investments = deposits), can never be managed by any attempt to control the cost of credit [or thru a series of temporary stair stepping or cascading pegging of policy rates, the ROI, or ROA, on government marketable securities; or thru “spreads”, “floors”, “ceilings”, “corridors”, “brackets”, IOeR, etc.].

    Economists should have learned the falsity of that assumption in the Dec. 1941-Mar. 1951 period. That was what the Treas. – Fed. Res. Accord of Mar. 1951 was all about. Keynes’ liquidity preference curve (demand for money) is a false doctrine.

    Monetary policy objectives should be formulated in terms of desired rates-of-change, roc’s, in monetary flows, M*Vt (volume X’s velocity), relative to roc’s in R-gDp. Roc’s in N-gDp (though “raw materials, intermediate goods and labor costs, which comprise the bulk of business spending are not treated in N-gDp”), can serve as a proxy figure for roc’s in all transactions, P*T, in Professor Irving Fisher’s truistic: “equation of exchange”. And Alfred Marshall’s cash-balances approach: “bridges the gaps of transition periods” in Yale Professor Irving Fisher’s model. Roc’s in R-gDp have to be used, of course, as a policy standard.

    — Michel de Nostredame

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