Do We Need to Rethink Macroeconomic Policy?

David Altig, research director at the Atlanta Fed and someone I've found to be very much worth listening to (even if I don't always agree), has a dissenting view on adopting a 4% inflation target in order to give central banks more room to maneuver in times of crisis:

Do we need to rethink macroeconomic policy?, by David Altig: The aftermath of a crisis is always fertile ground for big thoughts. Big thinking is exactly what we get from Olivier Blanchard (the International Monetary Fund's director of research) and his colleagues Giovanni Dell'Aricca and Paolo Mauro, in their new overview of the financial crisis and what it means for how we think about and, more importantly, practice macroeconomic policy. Titled, appropriately enough, "Rethinking Macroeconomic Policy," one of the more provocative parts of their analysis was highlighted in the Wall Street Journal:

"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."

Paul Krugman approves, as does Ken Houghton at Angry Bear, who concludes with this comment:

"None of the major Macro work ever done, from Barro forward, has ever found damage to economic growth from 4% inflation."

I suppose that the modifier "major" provides something of an escape clause, but as a general proposition there is at least some evidence that 2% is preferable to 4%. From the IMF itself, for example, there is this…

"The threshold level of inflation above which inflation significantly slows growth is estimated at 1–3 percent for industrial countries and 11–12 percent for developing countries. The negative and significant relationship between inflation and growth, for inflation rates above the threshold level, is quite robust..."

… which confirms the results of an earlier IMF study:

"Our more detailed results may be summarized briefly. First, there are two important nonlinearities in the inflation-growth relationship. At very low inflation rates (around 2–3 percent a year, or lower), inflation and growth are positively correlated. Otherwise, inflation and growth are negatively correlated…"

To be sure, there are plenty of studies suggesting modest increases in the rate of inflation from the levels currently targeted by many central banks would not be problematic—here, for example. But the point is that the evidence is not clear cut that an increase from an average rate of inflation in the neighborhood of 2 percent to the neighborhood of 4 percent would be innocuous. And there is always this element, noted by John Taylor in the aforementioned Wall Street Journal article:

"John Taylor, a Stanford University monetary-policy specialist who served in the Bush administration Treasury department, says that inflation could become hard to constrain if the target is raised. 'If you say it's 4%, why not 5% or 6%?' Mr. Taylor said. 'There's something that people understand about zero inflation.' "

So, the issue comes down to whether the uncertain costs of raising the average inflation rate is justified by the goal of avoiding the zero bound. At Free Exchange, the blog of The Economist, there is some skepticism:

"… the value of avoiding the zero bound depends on the seriousness of the macroeconomic situation. From the vantage point of 2010, a higher target rate seems like a great idea, but economic crises this severe are rare events. Even if there are only small costs to a 3% target relative to a 2% target, they may not be worth the trouble if the goal is to avoid serious trouble once every 80 years.

"There is a concern that with a higher level of inflation, inflation will become more volatile and expectations less anchored. At the same time, the higher target might not be enough to handle a recession as deep as the most recent downturn; to achieve the equivalent of a Taylor rule indicated -5% federal funds target without being constrained by the zero lower bound, the Fed would need to target inflation at at least 7%. Separately, these criticisms seem compelling, but taken together they cancel each other out."

Those are good arguments in my view, but my doubts about running policy to avoid the zero bound run even deeper. Among the lessons taken from the financial crisis, I include this: The "zero bound problem" was not all that big of a problem at all.

The Federal Open Market Committee moved the federal funds rate target to its effective lower bound (0 to ¼ percent) on Dec. 16, 2008. After a very rough start to 2009, gross domestic product (GDP) growth improved substantially in the second quarter. By the third quarter, growth was positive and, as far as we currently know, clocked in near 6 percent in the fourth. Is this the stuff of zero bound disaster?

In fact, Blanchard and company acknowledge that…

"It appears today that the world will likely avoid major deflation and thus avoid the deadly interaction of larger and larger deflation, higher and higher real interest rates, and a larger and larger output gap."

… but follow up with this:

"But it is clear that the zero nominal interest rate bound has proven costly."

Clear? Proven? I don't see it, and the IMF authors, in my view, explain why the zero bound problem was of limited relevance in the recent crisis:

"Markets are segmented, with specialized investors operating in specific markets. Most of the time, they are well linked through arbitrage. However, when, for some reason, some of the investors withdraw from that market (be it because of losses in some of their other activities, loss of access to some of their funds, or internal agency issues), the effect on prices can be very large. In this sense, wholesale funding is not fundamentally different from demand deposits, and the demand for liquidity extends far beyond banks. When this happens, rates are no longer linked through arbitrage, and the policy rate is no longer a sufficient instrument for policy." (I added the emphasis.)

The highlighted passage, of course, does not say "the policy rate is no longer a necessary instrument," and I certainly cannot prove that the trajectory of the economy in 2009 wouldn't have been better if only we had another 100 to 200 basis points in the tool kit. But color me a skeptic, and put me down on the petition to not experiment with higher inflation to avoid a problem that was not so clearly a problem.

I'm not yet on the 4% bandwagon, but I haven't ruled it out either. I'm still considering arguments on both sides of the issue. I do agree, however, with this point from Free Exchange. It's something I've worried about as well:

On the other hand, a higher inflation rate brings with it its own difficulties. Chief among these, according to Mssrs Billi and Kahn, are relative-price distortions. Not all prices inflate at the same rate, and so inflation generates some relative-price distortions which lead to resource misallocation. The higher the inflation rate, the greater these distortions (you can see a helpful discussion of these issues by James Hamilton here). After reviewing the costs and benefits, Mssrs Billi and Kahn conclude that a target just below 2% is optimal.

But the value of avoiding the zero bound depends on the seriousness of the macroeconomic situation. From the vantage point of 2010, a higher target rate seems like a great idea, but economic crises this severe are rare events. Even if there are only small costs to a 3% target relative to a 2% target, they may not be worth the trouble if the goal is to avoid serious trouble once every 80 years.

Just to be clear, the relative price of good A to good B is P_A/P_B. If there is inflation and one of the two prices is stickier than the other, then the two prices will change at different rates in response to inflation. This pushes relative prices away from their fundamental values, and this in turn distorts resource flows (which leads to losses and unemployment as resources are subsequently reallocated). The higher the inflation rate, the faster these prices become distorted and the higher the subsequent costs. This is not the only cost of inflation, but on this basis alone it's likely that at some point the costs of inflation will exceed the benefits. The hard question is where the breakpoint is (partly because we don't have good estimates of either the costs or the benefits, so it's possible to support most any position by picking and choosing among the empirical studies). I'd be very uncomfortable with a rate over 4%, 4% itself seems a bit high, but 3% isn't so hard to accept.

On the benefits, I agree with David, it's not that clear that the zero bound was the main impediment to policy action. This was a case where fear not high interest rates was the main factor causing investment to fall, and starting from a higher inflation rate target doesn't change that. Reducing fear means reducing risk, and that required the Fed to use other innovative policies rather than the standard interest rate policies that work during normal times. Fed purchases of toxic assets removes risk from the marketplace, various policies that amount to insurance policies on financial investments reduce fear, and so on -- these were the policies that made the most difference in terms of getting money flowing through these markets once again.

Maybe a higher inflation target will help. As I said my mind is open. People I respect greatly are on both sides of this issue -- there is no clear answer as to whether this would help -- and for me that is the problem. If I was more certain about the benefits, and less fearful of the costs, supporting a higher inflation target would be an easy call. But until the benefits are established more firmly than they are presently, I find it hard to support this without hedging on the recomendation.