The Other Rule
Brad DeLong’s famous rule (Originally: “If you think Paul Krugman must be wrong, you severely overestimated Niall Ferguson“) needs a corollary.
If Olivier Blanchard says your macroeconomic policy doesn’t work, and that you should double your inflation target to make it reasonable, it’s worth trying:
The International Monetary Fund’s top economist, Olivier Blanchard, says central bankers should consider aiming for a higher inflation rate than they do currently to lessen the chances of repeating the recent severe recession.
…[T]he global economic downturn revealed flaws in macroeconomic policy, especially the reliance primarily on interest rates to manage economies. Although Japan had fallen into a decade-long funk despite low inflation and low interest rates, “most people convinced themselves that the Japanese didn’t know what they were doing,” Mr. Blanchard said in an interview.
In particular, [Mr. Blanchard’s new paper with two other IMF economists, Giovanni Dell’Ariccia and Paolo Mauro] suggests shooting for a higher-level inflation in “normal time in order to increase the room for monetary policy to react to such shocks.” Central banks may want to target 4% inflation, rather than the 2% target that most central banks now try to achieve, the IMF paper says.
At a 4% inflation rate, Mr. Blanchard says, short-term interest rates in placid economies likely would be around 6% to 7%, giving central bankers far more room to cut rates before they get near zero, after which it is nearly impossible to cut short-term rates further.
None of the major Macro work ever done, from Barro forward, has ever found damage to economic growth from 4% inflation.
The paper is available here (PDF).
“In particular, [Mr. Blanchard’s new paper with two other IMF economists, Giovanni Dell’Ariccia and Paolo Mauro] suggests shooting for a higher-level inflation in “normal time in order to increase the room for monetary policy to react to such shocks.” Central banks may want to target 4% inflation, rather than the 2% target that most central banks now try to achieve, the IMF paper says.
At a 4% inflation rate, Mr. Blanchard says, short-term interest rates in placid economies likely would be around 6% to 7%, giving central bankers far more room to cut rates before they get near zero, after which it is nearly impossible to cut short-term rates further.”
Hear, hear! 🙂
Which is the second reason why the current central bank focus on zero inflation makes no sense.
Wag the dog’s tail (an probably get bitten). Fooling with the inflation rate to manage NGDP is a fool’s errand. Fiscal policy is the way to manage nominal aggregate demand, which drives national income and therefore capacity utilization. Moreover, targeting inflation and using employment as tool instead of a target is in violation of the Fed’s dual mandate.
Feds dual mandate?
They dropped employment as a target years ago. Whatever level of employment we have is the level we’re supposed to have. Dont you know, the invisible hand always knows best? We are just ignorant humans who try to interfere with our fate.
***None of the major Macro work ever done, from Barro forward, has ever found damage to economic growth from 4% inflation.***
I’d suggest that is because GDP growth probably is not the metric that you want to use for economic growth from inflation. What is needed is a metric that reflects a number of factors including at least real, per-capita, economic activity AND SAVINGS. Lower savings allow one to “borrow” growth from the future by taking on debt that fuels economic activity now at the cost of having to pay the economic activity back at some future time. Per capita debt in the US took off during the high inflation years of the 1970s and 1980s and has grown dramatically ever since. My contention is that high debt levels were responsible for the relatively low economic growth earlier in the decade.
Oh yeah. And we shouldn’t forget that CPI inflation was probably a very poor measure of inflation early this decade because it is dominated by Owner Equivalent Rent. OER managed to miss the significant inflation in real estate values early in the decade and kept on rising even after the economy had peaked and was suffering from massive deflation in real estate prices. I imagine that OER will lead to overestimating deflation just as it lead to underestimating inflation.
I wonder if macroeconomists shouldn’t focus on improving their metrics rather than speculating on correlations that may well be specious. Learn to walk before signing up to run a marathon as it were.
…CPI inflation was probably a very poor measure of inflation early this decade…
Fair point, but keep in mind that the Fed does not use CPI in its Taylor rule. The Fed uses the PCE. If you want to translate Blanchard’s recommendation into CPI terms, what he is saying is that we need a CPI inflation target of 5%-6%, which is roughly equivalent to a 4% PCE inflation rate. Blanchard’s point being that when you’re in a liquidity trap it is the problem of a nominal zero interest rate that ought to concern you. A higher inflation rate pads the nominal interest rate, which adds a few more bullets to the Fed’s policy holster.
Also, Blanchard wasn’t talking about a growth policy coming out of a recession, he was talking about setting a new Taylor rule target during normal times. His paper is about how to avoid the next liquidity trap. A higher inflation rate would not in and of itself adversely effect savings rates. What would affect savings is an accelerating rate of inflation, and that’s the tricky part.
***A higher inflation rate would not in and of itself adversely effect savings rates.***
An economist might believe that. No reasonable person is likely to. Especially no person who has lived through a bout of inflation. It may not fit your world view, but in the real world, inflation rewards consumption and eats savings. You can build a model where that’s not true, but if you try to implement it, it’s five to one that your model and reality are going to diverge very unpleasantly.
This is an interesting observation. Someone else made it on my own blog on my post where I pointed out why we want inflation in any economy that has fractional reserve lending (i.e., without inflation, the normal action of the business cycle is amplified by money fleeing the system during down cycles to become “mattress money” and thereby causing even further effective deflation than is explainable by banks increasing reserves during down cycles, since money under mattresses — AND ITS MULTIPLIERS — effectively ceases to exist as far as the monetary system is concerned). I suggested inflation targeting of 2-4% as numbers which we had plentiful evidence caused no harmful effects, pointing out that the ECB had a 2% inflation target, and my commenter pointed out that at 2% there were still parts of the economy in real deflation, and proposed 4% as a more reasonable inflation target.
Glad to see that there are now some “real” economists who are following up on this observation made by us “mere bloggers”. (Note that this observation was *not* original to me but has been floating around the econo-blogs for quite some time, it’s just now apparently managed to bubble into the open).
VtCodger, as 2slugbaits points out, only *accelerating* inflation affects savings. Just to explicate on the mechanism wherein only accelerating inflation affects savings: In a system where inflation is at a known predictable targeted rate, banks and other financial institutions can build it into the rates they pay you for your savings (e.g. if it is targetted at 4%, they can pay you something over 4%) so that savings are not lost to inflation, and they can set the spread on their loans to cover the interest they’re paying you.
In the late 1970’s, we were in a huge inflation overhang thanks to monetizing the costs of the Vietnam War + Apollo, and financial institutions could not build this unpredictable rate of inflation into their spreads. This directly caused the collapse of the S&L industry, because they had long-term mortgages issued in low-inflation times at a low rate as their primary asset yet short-term passbook savings as their primary liability which became payable immediately upon not paying sufficient interest to match other financial institutions. The result was an outflow of capital that could not be paid off in those pre-CDO times by selling off their loans (which in any case would have been sold off for pennies on the dollar because of the low interest rate they were loaned out at), forcing the S&L’s to engage in riskier and riskier investments to try to raise the money to keep depositors, until the whole ball of wax collapsed.
But if inflation rates had been targeted at 4% (or 6%, or 8%) all along, clearly that would not have been an issue, because then the S&L’s could have simply built that into all their rates to begin with, both their loan rates and their passbook savings rate. In short, for determining the effect of inflation upon savings rates it is the *predictability* of an inflation rate that is important, not the *scale* of an inflation rate. The S&L’s failed because inflation became unpredictable and future inflation did not match the inflation rate predicted at the time they issued loans, not because of inflation itself.
The idea that a higher level of inflation would help avoid liquidity traps has some obvious merit. But the notion that is is harmless seems to me to be hopelessly naive. There are two classes of problems with higher inflation as the norm.
The first is transitional. Targeting a higher inflation level would have winners and losers. Generally losers would be those with fixed incomes/revenues/rents and those who have invested in existing assets without inflation protection. In general lenders/savers get zonked. Winners would be those who have borrowed long term and get to pay off in depreciated dollars/drachma/marks. If rewarding imprudent investment isn’t moral hazard, I’d like to know what is.
In order to achieve any sort of equity for the participants it would seem to be necessary to index everything to inflation, alter all the low inflation expectation mechanisms like Proposition 13, and to establish a mechanism for redistributing the windfalls from the undeserving beneficiaries to those who have been screwed by the rule changes. Good luck on any of that.
The more subtle issue is that economists clearly do not know what the hell they are doing. There is no forerunner to the Hari Seldon Foundation that has reduced even the limited field of economic activity to a set of equations that predict anything accurately much less everything.
I think that if we had such a set of equations, it would probably be obvious that the idea that inflation is simply a scaling issue is really pretty naive. Is the scaling to a different inflation rate a matter of adding a constant to everything or one of multiplying everything by a constant. Or maybe there’s an exponent involved. Or maybe more than one of the above. If some things scale by adding K and others by multiplying by K’ and yet others by being raised to the K”th power, it’s very unlikely that the resulting system is going to work the same as the intial (ground) state for any combination of K,K’ and K”
Aren’t all of those problems equally applicable to a 2% target as well? Does going to a 4% target make the predictability problem any more of a problem? In any event, inflation is the one thing that the Fed does seem to be able to control fairly well. Actual inflation over the last 20 years has tracked fairly well with the Fed’s target rate. So maybe economists aren’t completely useless.
***Aren’t all of those problems equally applicable to a 2% target as well?***
The system has been tuned to 2%(roughly) inflation expectations. My point is that changing it to 4% isn’t as simple as many folks think. And it would have substantial consequences. Starting with a big enough jump in long term interest rates to raise howls of protest.
***Actual inflation over the last 20 years has tracked fairly well with the Fed’s target rate. So maybe economists aren’t completely useless.***.
It would be interesting to hear a Japanese opinion on that … after said Japanese had gone though a couple of bottle of Kirin and felt relieved of the obligation to be polite.
The inflation numbers measure only certain things. Things which for the most part are poorly correlated with monetary policy, whatever that is. For the most part asset prices are exempt from inflation calculations. Hell, they are even exempt from being being conceived as inflating when they rise. Of course when they fall the D word comes out quickly.
We have had stupendous inflation of financial assetsduring and after the Greenspan era, when you consider the mountains of new kinds of financial assets and their often rediculous prices. Housing as well was largely absent from inflation calculations. Because of couse RE was not inflating, it was ‘increasing in value’. Hogwash obviously.
It is rather crazy to talk about inflation anymore because its measure is stilted, fragmented and nonsensical. In any case the system has developed whereby monetary inputs flow mostly to the financial sphere, and then stays there. There is no way for the Fed or anyone to create the supposedly good inflation in the real transaction economy. Every coming round of QE and interest rate supression will inflated asset prices and do very little for the transaction people economy.
Japan has been in a liquidity trap for the past 20 years, so I’m not sure Japan is the example you really want to evoke. After all, the whole point here is to *avoid* a liquidity trap.
Regarding the system being tuned to 2% inflation expectations — yes, but. The spreads built into the system have sufficient overhead to deal with 4% inflation expectations. During the stagflation of the 1970’s, the system didn’t start creaking towards disaster until we headed past 5% inflation.
As for what self-destructive states do by passing things like Proposition 13, there is a *reason* why the State of California is basically a failed state now, less solvent than Greece by most measures, with a state credit rating basically as junk bonds. Political jurisdictions which refuse to cope with reality end up failed. This is as true today as it would if we raised the inflation target to 4% rather than leaving it at 2%, failed states don’t suddenly become unfailed states because of a 2% difference in inflation target. Political jurisdictions which are still functional and capable of dealing with reality will have no trouble adjusting to a new norm where the inflation target is 4%.
As for the notion that you can’t target inflation because economists don’t know what they’re doing: Nonsense. Monetary policy is one of the few things we *do* know how to do. Well, until you hit the zero bounds, anyhow, where you can print all the money in the world (300% of national GDP for Japan!) and all that happens is that it disappears under mattresses and ceases to contribute to economic activity. At that point economists start looking around baffled saying, “What do we do now?”
***We have had stupendous inflation of financial assetsduring and after the Greenspan era, when you consider the mountains of new kinds of financial assets and their often rediculous prices.***
That’s true. But there’s something curious underlying it which is a rather startling divergance between “sticker prices” and the probable price that would be received were any substantial part of the “inflated” instruments put on the market. Is it really inflation if one has to go to great lengths to make sure that real marketplaces don’t get a shot at setting the price?