Marcus Nunes has a new post that briefly compares the prospect of rising the inflation target to 4% versus NGDPLT. It’s a great read and I thought I’d weigh in on the subject.
But low inflation (and low expected inflation) goes together with low nominal interest rates. So the argument for a higher inflation target is an argument for higher nominal interest rates. And the only reason for that is to avoid another instance of the ZLB.
That reasoning flows from the view that monetary policy is interest rate policy that´s used to control aggregate demand and therefore the output gap. Oh! If only that were more or less precisely observed…
All I’ve really wanted from the start of my blogging “career” is for the tight money problem to be solved as a first, second, and third order of business, and so on… And increasing the target would go farther toward meeting that end than the status quo. But there are still problems with it that make it a third or fourth best choice.
Even if under the assumption that a 4% inflation target is doable, which is highly questionable given that the FOMC clown car doesn’t even do 2%, the effect would be putting a wig and lipstick on the IT pig because all of the undesirable things that come with explicit inflation targeting will still be there, with the most notable being the perverse incentive to induce and/or tolerate much lower levels of inflation than the state of economic health would indicate appropriate. At a much higher level it’s till IT and still means using demand side policy to control overall prices which I find appalling and could never in my right mind agree with.
I’ve heard many people say, for example, that gas prices are too high because the Fed has been too loose and we have too much demand for gas. I don’t look at it that way at all. We do not have too much demand for gas. We have too little gas for the demand. Because if we have these mandates that say the Fed shall achieve maximum employment, stable prices and moderate interest rates, then we need an ample supply of gasoline in order for all those folks to get to work. If we look at it as having too much demand for gas, the obvious conclusion is that we don’t have enough resources to support maximum employment and we must then create a bunch of have-nots in order to bring the price of gasoline in line with what people think they should be paying. That’s pretty close to what happened in 2007-2008, and it’s a given with the central banker IT mentality regardless of where in the inflation goal posts are set. Really, all raising the target to 4% would accomplish is something like saying we’ll tolerate a bit higher prices for gasoline before we start creating the have-nots; and that brings me back to the question of do-ability. People would start screaming about gas prices much before then; and so, it’s sort of an absurd idea without addressing the real problem of energy policy.
If the FOMC instead adopted a NGDPLT monetary framework, it would basically be saying that all it cares about is maintaining adequate demand and the supply side will have to be dealt with by supply side policy. It says we’re not going to manage supply side issues with monetary policy, which is the way I believe it ought to be. In fact, I’d like to find a different way to raise revenue for the transportation infrastructure instead of a gas tax, get the big oil lobbyists (rent seekers) out of the beltway, and stop overregulating the auto industry to allow transportation energy markets to evolve alternative fuels. As it stands, the government, regardless of what the politicians say, has us locked into the use of gasoline and won’t let go because it taxes it, with effective regulatory bans on nearly everything else – except the fuel of its choice – ethanol that has a mountain of problems on its own, namely its impact on the food supply and increased demand for farm land (which, by the way, is not absent of notice by the bubble hysterics). But I digress.
So as the thinking in support of raising the target to 4% goes, it would provide more breathing room before the FOMC feels the need to slam on the brakes making a reoccurrence of the over tightening of 2008 less likely. Looking at the transcripts of the 2008 FOMC meetings and seeing the statements regarding fears about headline inflation rising well above 4%, I would say it would not have done anything to prevent the calamity of 2008. Therefore, the argument that it would have made the Great Recession less great and less costly is questionable. So the question then becomes one about whether it would aid recovery.
In 2010, some members of the FOMC, concerned about central bank credibility, publically raised an alarm about inflation because headline inflation had risen above 2% even though unemployment was still above 9%. Of course that was wrongheaded, and a 4% target likely would have prevented the subsequent slowing in the second half of 2010. But this would not be a level target, and while there may not be an incentive for the FOMC to tighten policy on an economy that still needs to recover, there is no incentive to make up for missing the target. When the economy is in recession (or has nearly collapsed as in 2008) the mission of the central bank needs to switch to recovery mode, and level targeting would require that shift to action instead of just sitting there watching and waiting – oh maybe we’ll hit the target a decade hence…
And as I’ve mentioned before I am not an expert, but it seems like doing level targeting is the key, not necessarily the height of the goal post, and would probably have done more to at least aid recovery than merely raising the goal post.
So while raising the inflation target to 4%, if it were doable, would help to get us out of the current stagnation, it isn’t a real solution or a means of prevention for the long run. I would still much prefer NGDPLT.