How Urgent Is the Need for a Higher Inflation Target?
This morning I find myself distracted by reports that Tom Sargent believes that a 2%/year inflation trend is a costly redistribution of wealth from creditors to debtors that it would not be foolish to solve by restoring the gold standard. My reaction is: “WTF?!” I’m 99% certain that this is a misinterpretation…
And I also find myself distracted by the near-viral status of the Larry Summers IMF video. I know that Larry Summers has been thinking about using a [neo-Wicksellian model] to think about fiscal (and monetary, and regulatory) policy in a (near-permanent) low interest-rate environment since before we finished our [“Fiscal Policy in a Depressed Economy”]. And now his thoughts are developed enough for him to have taken them on the road to the IMF on November 8, 2013, and the talk has gone near-viral in the circles in which I travel (but alas, there is no(t yet) a transcript)…
Here we have Ryan Avent weighing in, advocating a shift in the target inflation rate in the North Atlantic from 2%/year to 5%/year, and complaining that Larry Summers won’t go there…
Let me make three points:
- Larry (and I) did go there in 1992, back when the target inflation rate seemed to us to be something like 4%/year and we were wary of dropping it: “On almost any theory of why inflation is costly, reducing inflation from 10 percent to 5 percent is likely to be much more beneficial than reducing it from 5 percent to zero. So austerity encounters diminishing returns. And there are potentially-important benefits of a policy of low positive inflation. It makes room for real interest rates to be negative at times, and for relative wages to adjust without the need for nominal wage declines…. OECD experience does not permit a judgment of the merits of very low inflation, since the two countries with the lowest average inflation rates after 1955, Switzerland and Germany, have inflation rates that have averaged 3 percent per year…. These two countries have growth records that are less than what one would have predicted on the basis of convergence effects and an assumption that each additional point on the central bank independent indexes carries the same growth benefits…. These arguments gain further weight when one considers the recent context of monetary policy in the United States. A large easing of monetary policy, as measured by interest rates, moderated but did not fully counteract the forces generating the recession that began in 1990. The relaxation of monetary policy seen over the past three years in the United States would have been arithmetically impossible had inflation and nominal interest rates both been three percentage points lower in 1989. Thus a more vigorous policy of reducing inflation to zero in the mid-1980s might have led to a recent recession much more severe than we have in fact seen…”
- On the other hand, Yuriy Gorodnichenko and Michael Weber have a powerful argument that if one takes the New Keynesian framework for analyzing nominal rigidities seriously, a 5%/year inflation rate does impose extra costs on the economy that are plausibly larger than benefits from reducing the variance of business cycles considered as fluctuations-about-trend (but not as falls below trend).
- It is not completely clear to me that, as Ryan maintains, the fact that interest rates cannot drop below zero is a purely nominal problem that could be solved by a high enough inflation target. If what is really going on is an excess demand for safe assets, a diversified basket of storable commodities provides a pretty good substitute for TIPS, and it has a zero yield: I need to think about this further.
EARLIER this month the IMF held a research conference in honour of Stanley Fischer. It featured a murderer’s row of macroeconomic stars as speakers including, to round out the event, one Larry Summers. The video of Mr Summers’ talk is now publicly available and is being heralded, with some justification, as an important and incisive piece of analysis. It also perfectly and maddeningly encapsulates the problem at the heart of the rich world’s economic debate—and its economy, for that matter. Mr Summers’ argument is… the rich world risks following the path blazed by Japan in the 1990s…. First, he points out, the expansion prior to the crisis was a strange one. Borrowing and asset prices soared, he notes, but by most key measures–capacity utilisation, unemployment, and inflation–the economy was not bumping up against its potential. “Even a great bubble wasn’t enough to produce any excess in aggregate demand,” Mr Summers says. And second, more than four years after the end of the downturn real output isn’t anywhere close to regaining its pre-crisis trend…. The way to explain these dyamics, he suggests, is to imagine that the real, natural rate of interest is negative. And so at prevailing rates of inflation there is no way to get short-run nominal interest rates low enough to generate the sort of strong recovery that used to be common after deep recessions. What’s more, he says, this state of affairs may persist for quite a long time….
I think it’s important and welcome for someone of Mr Summers’ stature to point out how serious a problem the zero lower bound is and to note that it is not going away any time soon. But this discussion sorely needs a dose of real talk, and soon. Or nominal talk, I should say…. The zero lower bound is a nominal problem. However low the real interest rate, an economy can keep nominal rates safely in positive territory by running a sufficiently high rate of inflation. Back in August, another eminent economist, Robert Hall of Stanford University, contributed a paper on the zero lower bound to the Kansas City Fed’s Jackson Hole conference, in which he estimated that the market-clearing real rate of interest is -4%. Now again, just why the real, natural rate of interest is currently -4% is an interesting question, but it’s irrelevant to the challenge of closing the output gap. All that matters there is that expected inflation is between 1% and 2% instead of near 4%. That’s the problem; that’s what’s keeping tens of millions of people out of work and hundreds of millions languishing in a perpetually weak economy: a couple of percentage points of inflation. And central banks are entirely to blame for that…. Central banks’ current inflation goals are inconsistent with a real recovery or a sustained exit from the zero lower bound. They should raise them and try to increase expectations of inflation.
Why isn’t this option on the table? Maybe it is…. But even the most radical policy shifts being entertained are probably too timid to prevent a zero-lower-bound relapse during the next contraction. And there is no sign of imminent adoption of even those too-timid radical options. And even when famous straight-shooters like Mr Summers are given a platform from which to shoot straight they all too often decline to argue for more inflation. Perhaps because that’s not the sort of thing this generation of economists does….
I keep coming back to this paper by Barry Eichengreen and Peter Temin, on the mentality of the gold standard:
The mentalité of the gold standard had developed during the long boom of the late 19th and early 20th centuries. It survived the shock of World War I and promised a safe haven for ships of state buffeted by stormy social, political and economic seas. Its anchor, however, proved a millstone around their necks…. Its rhetoric dominated discussion of public policy in the years before the Great Depression, and it sustained central bankers and political leaders as they imposed ever greater costs on ordinary people. The mentalité of the gold standard proved resistant to change even under the most pressing of economic circumstances…Basil Blackett observed in 1932:
…the gold standard has become a religion for some of the Boards of Central Banks…believed in with an emotional fervour which makes them incapable of an unprejudiced and objective examination of possible alternatives.
Countries only began the struggle to restore prosperity under new leadership, that of individuals who had not been party to the rhetoric of the gold standard in previous lives.
The belief in the critical importance of low and stable inflation is more flexible than the gold standard was, and it is born of a better understanding of the workings of the macroeconomy. But it is a binding constraint on recovery and prosperity all the same. And the unwillingness to question its continued utility in the face of evidence that it is doing real harm looks all too similar to the intellectual fetters that led central bankers to persist in foolish policy in the early 1930s.