Why Not a 4%/Year Inflation Target? Or a 6.5%/Year Nominal GDP Growth Target: Friday Focus: April 4, 2014

Let me first protest about the framing: it is not real inflation-adjusted risky interest rates that have been coming down for three decades: it is safe nominal interest rates, and even more so safe nominal interest rates that have been coming down (as the exaggerated early 1980s inflation premium has been wrung out). If we had a 4%/year inflation target in the North Atlantic, or if we had the gaps between expected returns on risky and safe nominal assets that back in the 1990s we thought of as normal, we would not have a big problem at all.

And I am still waiting for an argument as to why the obvious solution is a one-time permanent move to a 4%/year inflation target or a 6.5%/year nominal GDP growth target. Yuriy Gorodnichenko and Michael Weber (2013) provide one such argument, but I do not think it is strong enough to reverse what I see as a strong presumption that the right inflation target is 4%/year.

David Wessel’s take:

David Wessell: The Downward Drift in Inflation-Adjusted Interest Rates: Why? And So What?: “When Federal Reserve officials peer into the distant future…

…and imagine an economy closer to normal, they see short-term interest rates, adjusted for inflation, hovering around 4%.  If they hit their 2% target for inflation, that would bring inflation-adjusted interest rates to about 2%. But what if the economy has changed in ways that mean it cannot return to normal — to, say, 5.5% unemployment — at what were once considered normal levels of interest rates?… [Furceri and Pescatori] writing in the International Monetary Fund’s new World Economic Outlook note that inflation-adjusted interest rates have been coming down for more than three decades and suggests they may remain lower than normal for a very long time….

A long period of low interest rates, the IMF says, could be tough on pension funds and insurance companies that have promised to make payments in the future… tough on savers, but great for borrowers—governments included… boosts the risk that investors will do foolish things to get a little extra yield and provoke the much-dreaded “financial instability”… increases the likelihood the economy will spend a whole lot more time with nominal rates (that is, rates before adjustment for inflation) uncomfortably close to zero….

The IMF fingers three supply-and-demand factors to the downward trend in interest rates….

• The substantial increase in saving in China and other emerging markets, which former Fed Chairman Ben Bernanke labeled the “global savings glut.” (The greater the global supply of saving, the lower rates will be.)

• The increased demand for safe assets, which translated into strong demand for U.S. government and similar bonds, particularly by emerging markets that were building big foreign-exchange reserves. (The greater the demand for bonds, the lower rates will be.)

• And “a sharp and persistent decline in investment in advanced economies.” (The lesser the demand for funds for investment, the lower rates will be.)

The IMF economists see little reason any of these forces will be reversed soon.