In Sumner’s latest post on Econlog, he lays out some interesting points about the Bank of Japan’s situation:

Even though the rate of inflation since 2012 has been quite low (about 1%/year), after a period of deflation this represents an expansionary shock, as it’s more inflation than people expected.  Just as Friedman’s natural rate hypothesis predicted, the unexpectedly high inflation in Japan pushed unemployment below its natural rate.  Unemployment is now 2.7%, the lowest in 23 years.

  1. Japan has set an official inflation target of 2%. As Napoleon said, if you set out to take Vienna, then take Vienna.  If you are going to set an official inflation target, then you need to hit it in order to have a credible monetary policy.  If policy is not credible, it will be much harder to deal with the next crisis.

  2. Like most other central banks, the BOJ has foolishly decided to use interest rates as a policy instrument. If you are committed to using interest rates as a policy instrument, you need to make sure that inflation is high enough to avoid the zero bound situation. Even 2% inflation in Japan is probably not high enough to avoid the zero bound during a recession, but it’s better than 0% or 1% trend inflation.

Perhaps there are some nuanced points in this post that I am missing. But after reading it twice and looking at the fifty or so basis points of separation, it seems like I could cross out “Japan” and “BOJ” wherever they appear in the bulleted list and replace them with “ US” and “the Fed,” and it would still be mostly true, especially this part:

So Japan’s in a weird situation where it doesn’t need monetary stimulus, but the BOJ should nonetheless adopt monetary stimulus.  If it does not do so, Japan might fall into recession at a time when the BOJ had lost credibility.  That would require lots more QE and bond buying, just what the hawks are tying (sic) to avoid.  So my message to the Japanese hawks is simple.  If you want to avoid a lot of monetary stimulus later, do some more monetary stimulus now, until the 2% inflation rate is well entrenched.

The one point I might quibble with is the use of the natural rate hypothesis in explaining the inflation impact. There isn’t any question that monetary stimulus helped push the unemployment rate down, as would be expected when going from an ultra-tight money regime to something not so tight. But by definition the regime is still tight and whether whatever minuscule rate of inflation experienced in Japan is related to the natural rate and not general alleviation of economic repression is an open question.

Friedman’s natural rate hypothesis is a hypothesis, yet it is treated as fact by many, usually in incomplete ways such as citing the level of headline unemployment in a vacuum when that data point is only a slice of the bigger picture in how the employment market might impact inflation measures. As always, inflation is a nebulous term, and if anyone so brilliant is able to precisely disentangle the dynamics beyond of the realm of something that may rhyme with the natural rate hypothesis, they should be awarded a Nobel this year and every year thereafter because if there were any other source of confusion that has been more of a plague to mankind I’d struggle to identify it.

After digressing a bit, I really wanted to point out that the next to last paragraph of the post really drove home the Fed’s problem. In letting Fannie and Freddie go down in 2008 without comment or action, it lost any remaining credibility. It seems ironic then that after losing all credibility, the 2% PCE inflation target was officially announced and has been ignored by nearly everyone. The only credibility the Fed has is some varying and floorless degree of less that is explained away as fear of having to slam on the brakes in the future which is probably not the kind of credibility the Fed wants if it intends to avoid the ZLB, an event that should be at the top of the list of things to fear due to the ugliness of getting there and the professional failure signified by it.

The preference for nursing the explained fear of having to slam on the brakes in the future and chancing the ZLB is perplexing when the “better off” public policy formula appears to favor tolerating a slightly above target scenario compared to the ZLB scenario. The $64K question is why the Fed chances the ZLB scenario instead. Is there something I am missing in the cost/benefit analysis or is purposely playing with fire too much of an adrenaline rush to pass up?

PS: By the way, if the inflation target is symmetrical as is stressed in the the FOMC announcements, and it is been running below target PCE inflation since the target was announced, how much would inflation need to rise during the next recession in order to average 2% in the medium term? I haven’t sat down to do the calculation, but I suspect that on the back of an envelope it might be sort of unicorn-ish to make the claim that the FOMC will take Vienna when Vienna needs taken given the credibility problem.

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