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.