The Strange Anti Inflation Coalition
Why is the 2% inflation target sacred ? A very strong case can be made that a higher target would be better, because it would mean normal nominal interest rates are further from the (near) zero lower bound. DeLong and Summers made this point in the 90s . AEA President and former IMF head economist OJ Blanchard made it in 2010. Yet it gets nowhere. The 2% target is the gold standard of the 21st century. There is no historical or theoretical basis for it, yet gigantic sacrifices are made in its name. Really you should not push this crown of thorns about the head of labor and crucify mankind on a Keynesian cross at 2%.
I think the secret is an alliance between the extremely sophisticated (who don’t let mere data interfere with their theories) and the extremely unsophisticated (who assume nominal wages are exogenous). I’m going to talk about a debate in a mythical world in which Milton Friedman is right– there is a natural rate of unemployment and actual unemployment does not deviate from this rate for long or on average. It can briefly when inflation accelerates, because people have adaptive expectations so accelerating inflation is unexpected inflation. The argument also works in a mythical world were output is determined by a Lucas supply function.
Now there are three classes of agents. One is made of sophisticated and sensible people who understand the economy and care about the general well being (read me and my friends). Another is made of unsophisticated people who look at what happens and don’t understand the dynamics behind it. So they are boundedly rational and use ad hoc estimates based on something like regressions of the outcome of interest on what’s going on at the time to decide what to do. Finally there are sophisticated fanatics who understand the dynamics but are determined to prove that the government should just protect property rights and leave the market alone. This third groups also includes ordoliberals who claim to remember the German hyperinflation but not the suffering under Bruening during the Great Depression which was long ago and irrelevant to Europe (the Europe which matters because it doesn’t touch the Mediterranean) in the 21st century. The third group includes people who think inflation is theft, who think real interest rates should be high because thrift is a virtue and debt is a synonym for sin etc.
In this imaginary world and in the real world , an alliance of the unsophisticated and the fanatical determine policy making. Analysis after the jump.
OK Sophisticated Friedmanites recognise that loose monetary policy can only temporarily stimulate the economy. On the other hand, they also recognise that the exact same logic implies that the costs of steady inflation are tiny. They include costly efforts to reduce money holding (shoe leather costs) and the costs of updating prices (menu costs). Notably, both have become tiny as prices stamped on products have been replaced by bar codes and one label giving a price per item or unit price. Converting instruments which pay higher interest to money and back can be done on the internet. No need to wait in line at a bank (and ATMs don’t work only banking hours). Tbe costs of steady predictable inflation used to be tiny. Now it is tinier.
So the advantage of avoiding the occasional liquidity trap vastly outweighs the undetectible cost of a 4% target.
But you see people evaluate the effect of A rather than B on them by looking at how things change when one shifts from A to B. This is how we get addicted to drugs. This is why people are convinced sleeping pills help them even for pills which demonstrably have no effect on steady state insomnia. This is how we think more income will make us much happier (forgetting that consumption is generally addictive — this too is data based, reported contentment and happiness in Japan did not shoot up during the long incredible post war boom). In the model an increase in inflation causes lower real wages and a decrease causes higher real wages. People who want high wages hate inflation. But this is looking at the periods of transition and ignoring gradual adjustment. So unsophisticated people who think it is good for real wages to be high hate inflation. They conflate surprise inflation and expected inflation, note that surprise inflation causes low real wages and decide inflation is very costly.
Then over in economics departments there are 1970s Lucasians and new Keynesians who think nominal stickiness should be used to stabilize output. Roughly, they sometimes use models where the problem in periods of low output is excessively high real wages and try to think of ways to convince workers to accept lower real wages (I am thinking of leading new Keynesian and amazing GOP hack John Taylor). So low real wages are good, but can only be achieved with unexpected inflation. These guys want low wages and don’t conflate expected and unexpected inflation. They argue that there is no (lucas) or temporary benefits from a shift to loose monetary policy. They say there is a permanent effect on inflation. Then they pull a fast one. Having stressed the fact that they are very sophisticated and frankly advocated technocracy (here called independent central banks) they turn around and say we humble democratic brilliant technocrats must accept the public’s view of the objective function and people generally hate inflation. So we must assume there is some cost of steady predictable inflation which isn’t in our model (there’s no accounting for tastes). So countries must accept decades of high unemployment. The problem must be structural and the solution must be deregulation and crushing unions.
They go on to argue for rules rather than discretion, because policy makers are always eager to use surprise inflation to trick workers, because a sharp increase in inflation (and sharp decline in real wages) made Jimmy Carter so popular that he was invincible. I guess AngryBear has lots of readers who aren’t academic economists and who might be surprised if anyone made such a crazy argument. I promise you there have been times when almost everyone in academic macro made that argument (not just Fresh water macro also at MIT and Harvard).
But the alliance between people who think higher real wages would be good and that steady expected inflation causes lower real wages and the people who concede that lower real wages would be nice but steady expected inflation does not cause lower real wages sets policy. The technocratic elite and the general public disagree on everything, but their two disagreements cancel out and they both support the 2% target.
I what camp would you put John Cochrane who recently advocated going back to zero inflation. I comment on his lates here:
http://econospeak.blogspot.com/2019/07/why-is-john-cochrane-nodding-to-gold-bug.html
Now you will see that I agree that the inflation target should be increased (not decreased).
Robert,
I think 2 percent target started with the New Zealand central bank. Later it got picked up by the Fed, unofficially at first and then later officially, from where it just spread all over.
A major input into the Fed thinking came in the mid-90s when Janet Yellen was a governor and her husband, George Akerlof, was at Brookings and wrote a highly influential paper with Dickens and Perry that does not particularly fit into any of your schools, although probably more New Keynesian than anything else because it assumed downward stickiness of nominal wages, a generally accepted empirical phenomenon.
In the background lurking was also the idea that zero inflation preserves real value of fixed nominal incomes, which are out there. So there is a presumption that being as close to zero as possible has some benefits, not mentioned by you.
Anyway, the Akerlof et al paper argued that for micro efficiency purposes there need to be changes in relative real wages. Given downward stickiness, and correcting for productivity changes, this is likely to mean the adjustment must come by some wages rising more rapidly and probably pushing some prices up. So there is a micro efficiency argument for some positive inflation. 1 percent may be not quite enought, but 2 percent may be.
As it was, Greenspan heard of this argument from Yellen about the time he was accepting that zero may be too late. I think this is how it went down.
You just can’t waive a wand and “increase/decrease” “inflation”. The stupidity in this thread reaches nadir when driving oil prices to 200 Brent would get the job done. Why not do that?
The 2% “target” was really a balance point. In market economy producers control the economy. Rising inflation is as much producers trying to slow the economy down than anything else. Eventually you reach the point where they will destroy any nominal gains to reach a slowdown.
Bert – your comment shows you have no clue what this post was even about. To call the post stupid is pathetic. It was a good post which only a stupid person like you would fail to appreciate.
Barkley is right about New Zealand. An interesting speech delivered in 2014:
https://www.rbnz.govt.nz/research-and-publications/speeches/2014/speech2014-11-28
“It is now 25 years since the Reserve Bank of New Zealand Act came into force. The Act established the operational independence of the Reserve Bank (Bank) in respect of monetary policy, and specified price stability as the single monetary policy objective. A month later, the Minister of Finance and the Governor signed the first Policy Targets Agreement, which specified an annual inflation target of 0 to 2 percent. Through this reform New Zealand became the first country to formally adopt inflation targeting as its monetary policy regime – that is, setting the Reserve Bank the explicit goal of maintaining inflation in a range consistent with overall price stability, giving the Bank the independence to pursue that goal, and holding it – through its Governor in New Zealand’s case – accountable for reaching the price stability objective.” … Nevertheless, New Zealand’s macroeconomic record before and after the Reserve Bank Act came into effect indicates that its price stability objective has been met without any diminution in our economy’s long term growth rate. In the 20 years before the Act, annual real GDP growth averaged 2.2 percent while annual inflation was volatile around an average of 11.4 percent. Since 1990, annual inflation and real GDP growth have averaged 2.3 and 2.6 percent respectively and there has been a marked decline in inflation variability.”
I learned about this when doing some research on transfer pricing cases involving intercompany interest rates. Back in the 1980’s New Zealand has high nominal interest rates in large part because of its high and volatile inflation rates. But then they had their Paul Volcker moment in the late 1980’s. Eventually New Zealand overcame the initial recession from high real interest rates and inflation fell dramatically where it has said for now 30 years.
PGL:
I have it stuck in my head a target for inflation “use-to-be” 4%. I may have it confused with Unemployment. Of course, I am not going to find it on the internet. Any thoughts on the 4%? Thanks . . .
Sorry pgl, your wrong. Inflation targeting in general should be abolished. It doesn’t work and never has. Sometimes prices (oil driven especially) are going to fling up and down a bit no matter our best efforts. Sometimes all the inflation goes into assets………….like the 00’s mortgage bubble and the now topping junk bond bubble. If you count that in figures, things don’t seem what they are.
That is why getting rid of usury and debt driven capitalism would be useful.
Rising prices are how market economies signal rising demand, particularly demand rising to the point where changes in production become necessary. If you have a business running at 80% of capacity, demand can rise a fair bit, but at some point more equipment, more employees and/or new methods will become necessary.
Setting an inflation target is simply a way to prevent demand from rising so much that it requires business investment, expansion or transformation. It is about protecting incumbents at the expense of raising living standards. It is about preventing the need for capital formation.
Kalesberg:
If you are at 80% of capacity and it looks as if it will remain, you are at the limits of production and should be looking for more capacity or improved throughput. Typically in the past and I have been a part of this discussion, companies would come in and tell me or my upper management they would be increasing lead times due to demand. This does nothing to capacity and it in return builds a stream of orders. I would tell them such. Goldratt’s “The Goal” addresses such an issue in a fictional format. Other measures must be taken to increase capacity and/or throughput. If you take the order without an increase in capacity, you increase the backlog or logjam.
In their statements, Volcker, Greenspan, and Yellen openly attacked Labor as a way to control inflation, the issue of increased wages, and the resulting demand. Adding efficient capital would decrease the costs of a product with either capacity increase or better throughput and the latter could come at the expense of additional Labor. Just commenting and not picking your statement apart.
Adding something here. If we reduce labor input and increase throughput, what is the real issue in the cost of manufacture? Overhead which remains.
I thought it as a theoretical 4% in the past. It would not be the first time I thought something and was mistaken.
Barkely thanks for the history lesson. I didn’t know about New Zealand.
The Akerlof Dickens and Perry paper is paleo Keynesian. Indeed it is not at all related to the new Keynesian models in which price adjustment is slow, but zero isn’t an especially important number.
However, it is a formalization of arguments made by Solow and, mostly, Tobin in the 70s. Tobin made the argument for a downward sloping expectations unaugmented Phillips curve in his AEA presidential lecture in 1972. Solow argued it in 1978. Also Krugman has very much adopted it. Also, of course, 21st century data strongly support it.
The old Keynesian idea is that there is an expectations augmented Phillips curve, and expectations can be anchored. Anchored expectations meant people ignored inflation and not just that the optimal forecast of inflation happens to be constant (persistent shifts in inflation are noticed but the process isn’t simple or something like OLS bounded rational learning). This was the conventional view in say 1972. It is very clearly stated by Solow and Tobin.
Also there is downward nominal rigidity which can only be breached by unemployment far above the NAIRU. This means that there is an interval of possible steady states of unemployment not a single natural rate.
This was the state of the profession when Lucas revolutionized everything obtaining comparisons to Copernicus and Planck and such.
It is also the current view of leading macroeconomists including, for example current AEA president OJ Blanchard and, as mentioned, Krugman. It appears to me that there was a pointless 45 year detour.
A link
https://krugman.blogs.nytimes.com/2016/09/10/tobin-was-right-implicitly-wonkish/
Notice the date 1972. The rational expectations revolution stormed its Bastille in 1973. Also coincidentally there was an oil shock. As Krugman notes, he and his fellow grad students at MIT were convinced that Friedman had been proven right and that Keynesians who asserted that the unaugmented Phillips curve is an economic law had been proven wrong. They concluded they had to learn from Chicago and Minnesota (he’s written this many times). In fact, there seems to have been no more than one such Keynesian. The revolution stormed a straw Bastille. The case for a paradigm shift was based on intellectual fraud. See Macroeconomics and the Phillips Curve Myth by James Forder
also see
https://krugman.blogs.nytimes.com/2013/08/10/the-pigou-effect-double-super-special-wonkish/
Just an aside. Isn’t the actual experience in the last 30 years or so that it is almost impossible to lower nominal wages without laying off workers (perhaps because of co-ordination problems – or contract problems – or because of HR ideology) but easy to lower real wages via some inflation in those parts of the economy where lower real wages reflect current bargaining power. These average views actually hide a lot (same with the arguments about the need from growing nominal income in order to finance investment – note investment is needed in some places but not others). I actually don’t think too high real wages are always the cause of high employment, but I might think that high levels of inflation, low real interest rates and high levels of private indebtedness are not a healthy sign. But macro-economic balance (using a steady managed government deficit to create lowish inflation combined with relative tight and regulated monetary policy) is a somewhat different issue than the ideal target inflation rate. In my mind the killer argument for some inflation is to enable debtors to pay off debts, never mind the rest.
well, i hope the people who think this is an economics blog feel that they got their money’s worth today.
i have often disagreed with the commenters above. but i admire the expertise shown here. unfortunately i don’t know enough to have an opinion about the “rightness” of the expertise.
i do wonder if the economists are not making a mistake chasing some theoretical “solution,” when the real answer is to “just do the right thing” (morally right, not economically right) and let the markets adjust to that reality.
simple minded, but maybe not as naive as it appears.
BS says “In market economy producers control the economy.”
Does anyone really believe that? Do producers who make things for which there is no demand “control” the economy by going out of business?
Robert,
Generally agree. Yes, ADP is pretty paleo K, although George has long been identified as an early New K because of his emphasis on asyummetric information with this being a basis for wage stickiness in general, if not necessarily the rigid line at zero against nominal wage cuts.
That aspect really ties to George’s behavioral macro side, and he and Janet Y. have written several papers explaining that downward rigidity. Yes, it has to do with all sorts of social factors, which managers have long known about as Bewley showed in his famous survey study.. Funny how all this plalyed out as part of how we ended up with the 2 percent inflation target, which may have seen better days.
And, of course, I agree that rates was a distraction. Heck, I used to edit JEBO and now Review of Behavioral Economics, and I have never accepted NAIRU. I think one can argue that maybe there is at any given time a natural rate in the sense of a rate the economy would go to if there were “neutral policy,” if that can be defined. But we know it is endogenous to the actual rate and changes a lot, and there never was a credible argument that such a natural rate should equal NAIRU, and we have blown past those now several times without inflation taking off, but textbooks and so many commentators still spout this nonsense of natural rate equals NAIRU, and we had better watch out.
Arne
I wouldn’t hang Bert on his exact choice of words, or even that they convey an exact truth. Certainly a colorable case can be made that the owners of capital…the producers?… heavily influence the economy and the politics that enables it (them).
And that need not mean “all producers even the ones who go out of business.”
In a market economy people with money control the economy. However, they got that money.
If people trying to “control” the economy try to make it do something it cannot do, they will fail. Trying to sell things to people who have no money does not work. A market economy rewards successful suppliers out of balance with consumers, but calling that advantage “control” obscures the importance of the feedback that makes it actually work.
Arne
Heaven forbid that I should try to obscure the importance of feedback.
Still, if someone points a gun at my head and says, “Do this!” I would not want to obscure the importance of the power in his hand to compel my feedback, even as, of course, he is relying on my feedback to make it work.
It has always struck me as funny (no ha ha) that the pfree marketeers are never willing to let the market adjust to the feedback provided by the people trying to protect themselves from a machine that threatens to destroy itself by running out of control when they have jammed the throttle open.
Dale,
I think choice of words is very important. Heaven may not send lightning, but people who are only partly engaged see a big difference between influence and control, or between entitlements and insurance benefits.
Instead of asserting that producers control the market economy, I could assert that producers are simply reacting to the fact that consumers have more money and are buying more stuff. Producers react to this by hiring more people to make more stuff. This leads to a virtuous feedback cycle which eventually creates a bubble and then a recession.
Does this all sound more like producers jumping on the band wagon or producers in control?
Fixing the part where producers refuse to give workers more money for producing more requires workers to understand things well enough to coordinate their efforts.
Arne
choice of words is important but only as a first step in hopefully getting people to agree on what they are talking about.
Nancy Altman wrote a pretty good book about Social Security in which she carefully made the point that worker paid “insurance” is not “welfare.” Since then, indeed in her last chapter in that book, she has been trying to weasel around that distinction in order to turn Social Security into a universal welfare program.
Long standing convictions overwhelm careful wording every time.
Arne
what you are saying is, i think, pretty standard free market “theory.” and yes markets ultimately follow that theory as long as you understand that free markets operate within the constraints of gravity , entropy, human limitations, and political …. ahem…control.
we had an anti-trust act about a hundred years ago when people were finally convinced they had to limit the control of markets by the malefactors of great wealth (the winners of the earlier rounds of the free market game.
since then we have been watching round after round of the free-market-with-retrictions game. the malefactors of great wealth appear to be winning… to the extent they now decide just what restrictions will apply. they seem to favor those that favor themselves.
“workers” are hardly in a position to compete in that game.