On the Proper Inflation Target: Monday Focus for October 20, 2014

In the 60 years since 1954, the Federal Reserve has been moved to cut the 3-Mo. T-Bill rate when a recession threatens by 2.0%-points or more 13 times–once every 4.6 years. There have been eight cuts of 4.0%-points or more–once every 7.5 years. There have been five cuts of 5.0%-points or more–once every 12 years.

To me that suggests that the Greenspan-Bernanke policies–aim for 2.0%/year inflation, with a 300 basis-point “natural” short-term safe real interest rate on top of that when the economy is in the growth-along-the-potential-path phase of the business cycle–were already too restrictive. Once every 12 years is too often to run into ZLB problems, unless you are a strong believer in Coibion and Gorodnichenko arguments that price inertia is due to serious costs to businesses of altering price paths.

If you hold, with Jeremy Stein, that you are asking for trouble when T-Bill rates drop below 2%/year, and if you believe that secular factors have reduced the “natural” short-term safe real interest rate when the economy is in the growth-along-the-potential-path phase of the business cycle to 2%, and if you wish to have a 600 basis-point cushion to allow for appropriate cutting in a recession, then you should aim for a 6%/year inflation target.

If you don’t mind kissing the zero lower bound when you cut interest rates by 600 basis points, you could get away with a 4%/year inflation target.

And if you don’t mind dissing the zero lower bound and do not buy the argument that the “natural” short-term safe real interest rate when the economy is in the growth-along-the-potential-path phase of the business cycle is now not 3%/year but 2%/year, then you could get away with a 3%/year inflation target.

But I do not see how you can justify a 2%/year inflation target today.

Suppose that you want a 200-basis point cushion–that you are not happy with putting your commercial banks in a situation in which their business model requires that they take huge risks to even try to cover the costs of maintaining their ATMs and their branches–and buy the 2%/year “natural” short-term safe real interest rate when the economy is in the growth-along-the-potential-path phase of the business cycle, but recoil at a 6%/year inflation target as too high? What then? Then you have to go for régime change:

1. Reform fiscal policy so that–unlike 2008-present–it does its stimulative job to boost aggregate demand when interest rates are at their zero lower bound.
2. Move to some form of level targeting so that the inflation target is no longer fixed, but rises and rises sharply whenever aggregate demand or the price level undershoots its previously-expected growth path.
3. Allow the central bank to engage in expansionary fiscal policy on a large scale on its own say-so, via helicopter drops–the Social Credit solution.
4. Move to Miles Kimball Land

Those are the options…

Memo: Interest-rate cutting episodes since 1954: 2.9%-points, 2.1%, 2.0%, 5.0%, 2.2%, 4.5%, 8.5%, 9.0%, 3.2%, 2.5%, 5.0%, 4.3%, 9.5%-points (assuming the interest-rate rule called for cutting nominal rates in 2009 to -4.5%).