As a strong proponent for a higher inflation target I should address this column by Paul Volker in a full and complete manner. For right now though I want to say that I am making a case that I believe is substantially different from that the case Volker is arguing against.
He says
Rather, the danger is that if, in desperation, we turn to deliberately seeking inflation to solve real problems — our economic imbalances, sluggish productivity, and excessive leverage — we would soon find that a little inflation doesn’t work. Then the instinct will be to do a little more — a seemingly temporary and “reasonable” 4 percent becomes 5, and then 6 and so on.
My point is not simply – as seems to be Ken Rogoff’s – that a jolt of inflation inflation would be good for the economy right now – though I believe it would be.
My case is that 2% inflation is a fundamentally bad idea. I argue that 4% inflation is not merely “OK” it is preferable. It is preferable because even in normal times it produces higher nominal interest rates. Higher nominal interest rates in turn give the Fed more leverage under traditional monetary policy.
When you consider the long run costs of inflation you have to consider that there will be unanticipated events. Some of those events will be deflationary. If you don’t have an adequate buffer the Federal Funds rate will bump up against zero.
When you look at the grand scheme, I think it is precisely the problem of government failure that should lead us to prefer a moderate level of inflation. We simply do not have the tools to ensure that NGDP, the price level or whatever target you want is always hit.
We need room to miss. 2% gives us very little margin for error.
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Tuesday ~ September 20th, 2011 at 3:53 am
genauer
some nitpicking first: it is Volcker with a “c”
And I fully agree with Volcker. We had this in the70 ties: with a German chancellor uttering: better 5 % Inflation than 5 % Unemployment (Germany had something like 2 % in 1970) and at his End we had both at 6 %. Happy times. And a republican Nixon resorting to government price controls !!
The point of 2.0 % inflation mainland Europe or 2.5 US, 3.0 UK targeting, is that people tolerate just this margin of error, without switching into the mode of constant re-adjusting. But at higher numbers that will change, and all the assumed benefit is not only lost, but with 3 % inflation, people will demand a 4 % increase, and so on.
We had this, until 1980, this is just 30 years ago.
And the problem with a lot of European countries is, that they still have indexing of wages and pensions, which prohibit gradual adjustments, like we did in Germany and other northern European countries.
And NGDP targeting is like taking a BMW on the highway to hell.
Tuesday ~ September 20th, 2011 at 7:26 am
anon
AIUI, the “zero lower bound” on interest rates can be addressed by a combination of level targeting (i.e. committing to making up for previous deviations, which keeps expectations on target), unconventional policy/QE and negative Fed rates.
Our current problem is not the zero bound on interest rates, it’s supply shocks combined with a de-facto 1%–2% inflation target. The monetary reaction to large supply shocks is causing an AD shortfall.
Tuesday ~ September 20th, 2011 at 11:07 am
jsalvati
You must know the arguments for why interest rates are not the correct way to understand monetary policy; Sumner has been around for a while and, heck, your own co-blogger Niklas Blanchard is a monetary disequilibrium guy. But you still continue to talk about monetary policy in terms of interest rates. Can you elaborate on why you think interest rates are the correct way to think about monetary policy?
Tuesday ~ September 20th, 2011 at 2:46 pm
Mitch
Karl, it seems to me that there’s a trade-off. Because of that, I’m not sure if you’re right or if you’re wrong.
As “genauer” above me writes, having higher inflation, year after year, brings its own costs. People notice inflation much more at 4% than when it’s only 2%, and they’re more likely to preemptively take action to not fall behind inflation. The economy’s natural state becomes more inflationary, and because of that, a higher unemployment rate is probably necessary to keep inflation steady at 4%. (That is, I’m saying that I believe having a higher inflation rate will eventually increase the NAIRU). I could be wrong about this, but if so, why?
The cost of higher inflation (a higher NAIRU) needs to be weighed against the risks you point out, which I agree are real. It really is bad if we end up in a liquidity trap. In that situation, we can’t always expect fiscal policy to come to the rescue, because as we’ve seen over the past few years, the political leadership in most countries can’t be relied on to do the right thing, for whatever reasons.
So Karl, I guess my question for you (and this is a serious question): how do you weigh one risk against the other, and what made you settle on 4% inflation (rather than, say, 3% or some other rate)?
Tuesday ~ September 20th, 2011 at 3:21 pm
Dan Braganca
Karl, could you or one of the commenters here briefly explain (or link something) that explains why the “Federal Funds rate [bumping] up against zero” would be a bad thing? Thanks.
Tuesday ~ September 20th, 2011 at 3:35 pm
Mitch
Dan, when nominal interest rates reach zero, they can’t be lowered any further. Sometimes, if aggregate demand is especially low, the real interest rate that would lead to healthy economic growth and eventually full employment is negative. If we have inflation, low or zero nominal interest rates can give us the negative real inflation rates we need.
This picture shows what’s happening now, in the IS-LM model: http://economistsview.typepad.com/.a/6a00d83451b33869e201538f4ac8d8970b-800wi
This picture shows the IS-LM model in a normal healthy economy:
http://broward-tutor.com/images/IS-LM-model.gif
Do a search for “IS-LM model” and “liquidity trap” or “zero lower bound” to get a more detailed explanation of what I’m talking about.
Tuesday ~ September 20th, 2011 at 3:46 pm
genauer
Dan,
I do know this AD shortfall argument inside out, why ZLB is in general a bad thing, don’t you worry. And for a while I was also following this thought, you have to get control over real interest rates. And this works, in a certain way, yes. I liked to compare this with sailing, you need some pressure on the rudder, in order to be able to steer.
But we are not in the late seventies, with debt / GDP low in most nations,
and the demography not a real concern in the minds of most people, and doing something like this (raising inflation by a substantial margin), for more than a few years has long term bad consequences.
Trust me, about a year ago, I tried to calibrate from historic data, how much and in what way you can do this inflating away your debt, arguing for it with a friend : – )
But 4 things are different now:
a) everybody knows that there are no growth miracles, with TFP at 1 – 1.5 %, and the given demographics
b) overall private and public debt is much higher now
c) capital can move freely across (at least the western) world
d) counter examples like northern europe and many asian countries do exist
And, it is not a “supply shock”, no factories were swallowed by earthquakes or enemy bombing.
It is not a debt “shock”, it is a structural long-term debt /over-consumption problem.
I just realize, while typing, that Dan might have asked for himself (selfish me). Nevertheless, I think my thoughts might shape an answer for him in a good way.
Tuesday ~ September 20th, 2011 at 4:04 pm
Mitch
Woops, correction needed. I said “the negative real inflation rates we need.”, when I should have said “the negative real INTEREST rates we need.”
Also, I referred to aggregate demand, when that’s not really what the IS curve is, although for your purposes thinking about it that way may be okay.
Tuesday ~ September 20th, 2011 at 6:57 pm
Ride of the Volckery « Renaissance Roundtable
[...] Karl Smith: My case is that 2% inflation is a fundamentally bad idea. I argue that 4% inflation is not merely “OK” it is preferable. It is preferable because in even in normal times it produces higher nominal interest rates. Higher nominal interest rates in turn give the Fed more leverage under traditional monetary policy. [...]