A Call for Action: Conditional Inflation Targetting

From an article by myself and Jeffry Frieden in the newly released Foreign Policy:

[We need] inflation — just enough to reduce the debt burden to more manageable levels, which probably means in the 4 to 6 percent range for several years. The Fed could accomplish this by adopting a flexible inflation target, one pegged to the rate of unemployment. Chicago Fed President Charles Evans has proposed something very similar, a policy that would keep the Fed funds rate near zero and supplemented with other quantitative measures as long as unemployment remained above 7 percent or inflation stayed below 3 percent. Making the unemployment target explicit would also serve to constrain inflationary expectations: As the unemployment rate fell, the inflation target would fall with it.

Today our highest priority should be to stimulate investment, growth, and employment. Raising the expected inflation rate will lower real interest rates and spur investment and consumption. It will also make it difficult for the de facto dollar peggers, such as China, to sustain their policies. The resulting real depreciation of the dollar would stimulate production of U.S. exports and domestic goods that compete with imports, boosting American production. The United States would get faster growth, an accelerated process of deleveraging, a quicker recovery, and a firmer foundation upon which to address long-term fiscal problems.

We believe a similar policy regime is necessary for the euro area. Figure 1 highlights the distance we still need to go in the US to achieve a level of leverage consistent with resumed consumption growth.


Figure 1: “At current speed of de-leveraging we will reach pre-bubble level of debt/income in 2013” from Torsten Slok, “US Consumer Deleveraging: More adjustment needed,” Deutsche Bank, December 2011.

This proposal follows from the conclusions we made in Lost Decades:

Americans face serious economic challenges. They lost the first
decade of the century to a boom that enriched the wealthiest, and
a subsequent bust that impoverished the rest. Now they risk losing
another decade to an incomplete recovery and economic stagnation.

None of the changes necessary to avoid a repeat of this disaster
will be easy. At every turn there are major political obstacles. Financial
interests resist regulations that shift the burden of risky behavior
back onto them and off of taxpayers. Beneficiaries of government
programs fight against attempts to curb their benefits. Taxpayers
refuse to pay the taxes needed to pay for the programs they want.
Partisan politicians block reasoned discussion, suggesting absurd
pseudo-solutions instead of realistic alternatives. Ideologues and
political opportunists encourage Americans to cling to the childish
things that have served them so poorly in the past: a mindless
belief that markets are perfect, that tax cuts solve every ill, that borrowing
is to be encouraged. Despite the great trouble these policies
have caused, their attractions continue to be touted and spouted by
unprincipled pundits.

Of these childish things is an unwarranted fear of inflation.


Figure 2: Implied inflation calculated as difference between constant maturity TIPS yields on five year Treasurys (blue), seven year (chartreuse), and ten year (red). Observations for December apply to December 28th observation. Source: St. Louis Fed FRED, and author’s calculations.

Link to Menzie Chinn and Jeffry Frieden, “How to save the global economy: Whip up inflation. Now,” Foreign Policy December/January 2012.

42 thoughts on “A Call for Action: Conditional Inflation Targetting

  1. David Beckworth

    Your conditional inflation targeting is not that different from a price level or nominal GDP level target. As a past advocate of nominal GDP targeting, why didn’t you push it instead of conditional inflation targeting?

  2. p

    As Keynes claimed in his Economic Consequences of the Peace, “Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some…The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

  3. W.C. Varones

    We’re not proposing a lot of inflation — just enough to reduce the debt burden to more manageable levels, which probably means in the 4 to 6 percent range for several years.
    4 to 6 percent compounded for several years is not a lot of inflation? I’d hate to see what is!
    Not that I disagree. I’ve been saying for years that devaluation is the only way out of the mess the central planners have gotten us into.

  4. Bob_in_MA

    What would happen to t-bonds? You’d basically be telling the holders of debt that they are going to get hammered by an intentional policy. And I believe a great deal of the debt is at the short end of the yield curve. In other words, the market could make it’s displeasure felt really quickly and the cost of the servicing the debt jump.
    Also, Fed policy is a lot better at increasing asset and commodity inflation than wage inflation. If wages don’t follow, 4-6% CPI would be deadly to this economy.
    I don’t think this is the easy way out you envision.

  5. maynardGkeynes

    Having lived through the Carter years inflation, I can tell you that the people you are trying to help, presumably middle class and working class Americans, will not thank you rescuing them with 4-6% inflation. They are more likely to hang you with the aforementioned Lenin’s rope. Average people hate inflation, and don’t see it as a good thing at all for their economic and social well-being. I hope you and economists like Krugman and DeLong will acknowledge that, quite possibly, these folks know what’s good for themselves and their families better than you do.

  6. c thomson

    So…with the help of a few technocrats we will smoothly turn inflation up a few notches, then turn it down again at just the right moment?
    And the Chinese, Indians, Japanese and Europeans will accept a pleasing little depreciation of the dollar?
    Congratulations! Now please turn to the mysteries of the universe…

  7. C Jones

    Is there not a differentiation required between inflation defined as rising cost of living with no improvement in wages Vs inflation defined as wages and pricing both rising at 4-6% ?
    I think people fear more of the former and understandably can’t see how this solves any economies problems ..?

  8. Rich Berger

    In other words, let’s screw all those who have lent money to the US government. This is worthy of a third world country.

  9. ReturnFreeRisk

    I am still not convinced. How do you propose to ease PRIVATE debt burdens through inflation? With nominal wages stagnant, it is impossible, no? If the people do not get wage hikes, inflation just makes them worse off. The only entity that benefits from inflation is the government. BUT the US govt does NOT need debt relief. They are borrowing at rock bottom rates in record quantitites. So what we need is the government to take private debt on their own balance sheet (mass debt forgiveness) and then finance it through a combination of low rates and higher inflation.

  10. ppcm

    May we check, whether recent past inflationary policies have succeeded.When factoring that embedded in the HCIP is a very inflation lineant Laspeyres accounting..
    Statistical Data Warehouse
    Inflation rate (HICP)
    Of course “nothing is lost, nothing is created and everything is transformed”.When the Eurozone inflation was trending towards its pick the labor cost was at the optimal cost point.
    Unit labour costs
    The labour productivity is unfortunatly inversely proportional to inflation,to labour costs
    It is tempting to see the end of the Bank of England experiment in a running away through inflation .
    Inflation.eu Inflation Great Britain – current British inflation
    Note that UK employment is not improving on a trend.
    Would inflation solve insolvency or make it worse, the latter rather than the former as interest rates may rise the interest rates burden will show its toll.
    Would inflation solve the structural problem of unemployment,it did not in the past short term history,why should it change now?
    If history is a guidance inflation,unemployment,eroding savings are the salpeter of the social explosion.

  11. Anonymous

    ReturnFreeRisk made the main point I was going to make. Inflation only helps with debt if the debtor’s nominal income rises along with nominal prices. But in an economy with massive unemployment and negligible worker bargaining power in an inflationary environment, nominal incomes will tend to increase at a rate lagging behind the increase in the price level. So there will be minimal debt relief.
    Of course, decreasing real wages and labor costs is a motive that often stands behind inflationist proposals, which many of the current enthusiasts for inflation targeting or NGDP level targeting are usually willing to admit. Personally, I don’t think Americans are on the whole overpaid. I especially don’t think that the Americans most likely to be impacted by inflation engineering – those at the bottom – are overpaid.
    I tend to doubt that the Fed is actually capable of hitting the inflation target – but that is another matter.
    A more promising policy would be to boost incomes. employment and aggregate demand directly in the high-consuming parts of the economy at the bottom and middle income scales by a combination of redistributive taxation and money-financed deficits, and also a federal jobs program. We might get some inflation in that case, but at least the inflation would be a causal consequence of real income growth among the class of consumers, rather than a crude attempt to engineer income growth through the bank channel alone.

  12. aaron

    “In other words, let’s screw all those who have lent money to the US government. This is worthy of a third world country.”
    When you put it like that, it kind of sells the policy.
    Screw people who lent to the government. They were enablers.

  13. jason

    C Jones is right, we really need new terminology to differentiate between different kinds of inflation.
    Price and wage increases sparked by customers everywhere spending more money on products and services is greeted with applause. Call it inflation and people recoil in horror.

  14. jonathan

    To other commenters, the difference between this and nominal inflation targeting – note it’s not double t, as the post titled is misspelled – is the link to unemployment.
    I think the post might have added that moderate inflation is a better prescription for growth under the current circumstances. Since we are nowhere near full output and have an excess of money held in short-term instruments, moderate inflation encourages putting money to use.

  15. Buzzcut

    With a deficit over a trillion dollars, with the dollar at levels to the yen never seen before (with the BOJ intervening to try to get it above 77, and failing), with interest rates so low they are negative in real terms, doesn’t it seem like we’ve done everything we possibly can to get inflation?

  16. Menzie Chinn

    jonathan: In my youth, I spent some time in Canada, so you will excuse my use of Commonwealth spelling of “targeting”. I will try to hew to the American usage if the word “aluminium” ever comes up.

  17. tj

    By what channel will inflation be created with so much slack in the economy? Recent increases in excess reserves seem to have had little direct effect on the real economy. How long of a lag do you see between the increase in inflation and an increase in real wages for the private sector?

  18. Some Guy

    My $200 weekly grocery bill and $75 weekly gas costs don’t seem to jibe with your 2% inflation number. One suspects that the inflation numbers the working poor care about are substantially higher than you think. But if it’s not in the government statistics, maybe it doesn’t matter?

  19. Steven Kopits

    This approach implies some sort of Laffer curve, no? At low levels of debt, people pay back their loans because they can and want access to more credit. At very high levels, people lose the incentive to work or invest because all (incremental) income is captured by the creditor. So there is some sort of optimal zone, snd once you’ve passed it, default (or expropriation) is a more effective measure for stimulating growth than attempting to repay the loan. I could accept that, and it’s why I felt Greece would do better to default and devalue, rather than trying to stick it out.
    I would note that this speaks against Krugman’s Richardian equivalence. We don’t owe the money to ourselves. Some of us (the taxpayers) owe the money others of us (bond holders). Given high enough levels of debt, both taxpayers and bondholders will cling to their property rights, and you’ll get a financial crisis a la Greece. By this line of thinking, the loss to the economy is not the transfer of property rights, but their lingering in limbo. A foreclosed home which has been sold to a new owner creates certainty. A home which may be foreclosed creates uncertainty to the home owner, the bank, the housing market, and real estate construction business. This uncertainty impedes investment. Thus, the lack of AD is caused by instability in property rights caused by excessive borrowing. Inflation, through the process of soft expropriation, creates certainty. To my mind, yes, such an approach could work in the current circumstances (but not in the 1970s, which was not accompanied by a financial crisis). And of course, this assumes (along with the myriad caveats noted above) that we’re not constrained on the oil side, which, to all appearances, we are.

  20. ReturnFreeRisk

    In the absence of fiscal stimulus that meaningfully pushes the economy toward full employment/output gap, HOW DOES THE FED raise inflation? With even the Obama administration favoring austerity (let alone the GOP), how does Bernanke produce inflation that is broad based? (let us ignore the temporary hysterics of the oil and gold traders). I find these suggestions of raising inflation a discussion without a point – we will not be able to do it.

  21. Menzie Chinn

    David Beckworth: I think the equivalence depends on the nature of the shocks (see e.g., Frankel with Chinn (JMCB, 1995), and whether in fact one targets nominal GDP or the first difference of log nominal GDP.

    Conditional targetting highlights the factors one is interested in — unemployment and inflation. In addition, unemployment is not subject to revision, and while PCE is, I think it’s less so than nominal GDP, which is available only at the quarterly frequency. While monthly GDP (such as the e-forecasting and Macroeconomic Advisers series) is available at a higher frequency, they too are subject to substantial revisions.

    I think there is also a benefit to staying close to the existing framework, and having a long run inflation target that anchors long term inflation expectations.

    Some Guy: While there is a difference between the average inflation rate and the median income inflation rate, I don’t think at the moment there’s a big difference (at least not the last time I did the comparison, a few months ago). For discussion of plutocratic vs. democratic indices, see [a] [b] [c].

    Various: Some have asked how the higher target will induce lower unemployment and higher inflation. A higher target would give more latitude to policymakers to take additional measures such as additional quantitative easing, or reducing interest rates paid on reserves. So I respectfully disagree with those argue achieving higher interest rates is not feasible.

  22. don

    “In other words, let’s screw all those who have lent money to the US government. This is worthy of a third world country.”
    Menzie apparently thinks China will be among the losers, based on his interpretation of data on the maturity of debt held by China (from an earlier post, in his reply to my comment). Looking at the same data, I continue to respectfully disagree.
    As for creating inflation, the whole game is expectations. I sincerely doubt the Fed can change these smoothly. Rather, I suspect lurches from very little inflation/deflation to damaging, and hard to control, inflation.
    As for the benefits if they achieve inflation, I am with those who fear that the result will be to facilitate real wage adjustment (downward). I also believe a non-negligible amount of the currently-required adjustment would go away if Asian currency pegs were to end.

  23. wgsimpson

    Inflation at 4% a year will halve your savings in 13 years.
    That is penalising the innocent for the sins of others (Government, Bankers)

  24. WGSimpson

    5% inflation halves one’s savings in 13.5 years.
    The point remains that this is already penalising the innocent thrifty to rescue the profligate Government (and the Banks whose debt they readily absorbed, rather than allow market disposal of rubbish assets and daft bankers at their true value!)

  25. Ricardo

    Let me see if I have this right? The house is rotting away but if we just continue to pour on the whitewash long enough the house will repair itself. Do I have it about right?

  26. ReturnFreeRisk

    Quantitative Easing has not done much in terms of raising inflation expectations. The break even inflation indeed went up but that is driven by the whims of gold traders and oil traders.

  27. Menzie Chinn

    Ricardo You posted this metaphor as a comment on this and the next post. Do you (a) have anything original to add, and/or (b) ever work with numbers as opposed to fables?

  28. MarkS

    The US economy was juiced by about $1.3 Trillion in Federal deficit spending and $0.6 Trillion in QE2 during 2011… How much more institutional largess do you think will be necessary to lift inflation to the 4-6% range, when the handwriting in Congress indicates incipient reduction in fiscal pump priming?
    Because of the US dollar’s preeminent position as an international reserve currency, its unlikely that multinational corporations and international bankers will support dilution of their holdings. Unless of course, they are paid off by direct access to the new money…
    The sad fact is that America can’t behave like Argentina unless it is willing to give up its international privileges. Re-inflation of the credit bubble ain’t going to happen when the BIS is tightening bank reserve requirements. Re-inflation ain’t going to happen when one-third of the mortgage market is impaired and a huge stock of mothballed slowly moving real estate inventory waits in the wings.

  29. Anonymous

    5% inflation halves one’s savings in 13.5 years.
    Only if you are stupid enough to stuff your savings under a mattress.

  30. 2slugbaits

    Awhile back, and without particularly endorsing it, Menzie linked to a paper that argued a 4% inflation target would not be a good idea. I’m doing this from memory, but as I recall the argument was that each incremental increase in the inflation target also increased the likelihood of accerlating inflationary expectations, which would hurt welfare over the long run. At the time I didn’t find the paper particularly convincing for several reasons, not the least of which being that the author’s methodology did not seem to account for regime shifts. It was also biased in the sense that inflationary experiences were overrepresented and not enough weight was placed on the debilitating effects of prolonged disinflation/deflation. In any event, I’m glad to see Menzie coming out four square for a higher inflation target. I just hope the Fed can pull it off. And we better hope Obama wins re-election or Ben Bernanke might find himself the victim of Texas justice, traitor that he is.
    Rich Berger and WGSimpson: First, why didn’t those bondholders buy TIPS if they were worried about inflation? Second, if it’s unjust to bondholders for the Fed to overshoot its ex ante inflation target, is it not also unjust to borrowers if the Fed consistently undershoots inflation targets? Why is inflation unjust while deflation is somehow “fair and balanced”?

  31. Ricardo

    I work with numbers when they are meaningful, sometimes in micro-economic situations. I work in fables as parables to illustrate errors in reasoning.

  32. aaron

    Mark, those are good numbers. Of the 1.3, how much was transfers and how much was spending (which GDP by definition). The .6 trillion monetary and assuming the govs stimulus was 1/5 spending in the same year, that would account for 7% of GDP that year. The question is how much of the next year’s GDP depends on multiplier effects of those distributions of money.

  33. aaron

    Also, the continuing budget resolutions essentially increase the size and duration of the stimulus.

  34. 2slugbaits

    aaron Stimulus is normally thought of as a change in spending, not a continuation of existing spending patterns. So how is a continuing budget resolution new stimulus?

  35. dwb

    “we need more inflation” -> not really, we need higher (nominal) incomes. higher nominal incomes could come through inflation, real wage growth. the latter is preferable to the former.
    Your chart points out the household debt/income ratio. This is important for another reason: financial deleveraging (disintermediation) is directly related to declining nominal incomes. declining incomes-> higher debt service (income/debt) -> higher bankruptcies/defaults -> credit contraction -> lower spending -> declining incomes. its a vicious circle which leads to financial instability.
    again, increasing real incomes and zero inflation is far preferrable to higher inflation and stagnant or declining wages.
    but, that is one reason why the fed should adopt a nominal income target not an inflation target.
    you seem to favor a higher inflation target because for practical reasons – “it fits in the current framework” and we do not know enough about gdp in real-time. But inflation has similar issues – the Fed looks at “core,” trimmed mean, and other indicators because the true “trend” inflation is not known (and inflation estimates themselves are upward biased). sure unemployment is not subject to revision, but that does not make it any more accurate.
    seems to me targeting the correct metric (nominal income) and using imperfect proxies (inflation, unemployment) as guides until we get better data is far better than targting imperfect proxies themselves (which installs bureaucratic inertia to keep them the same bad metrics they are now).
    I have not seen anywhere that a nominal gdp target implies a positive inflation rate by the way. I have seen a 4-5% nominal gdp target (which implies a 1-2% GDP deflator) but the 1-2% gdp deflator is in no way meant to imply 1-2% actual inflation – its merely a reflection of the fact that its an upward biased estimate of underlying true inflation (.5-1.5%). In fact, i think its the opposite: nominal gdp targeting implies zero (true) inflation on average (even though its imperfectly measured).

  36. don

    5% inflation halves one’s savings in 13.5 years.
    Only if you are stupid enough to stuff your savings under a mattress.
    In my experience, inflation tends to reduce the real after-tax return to savings. Arbitrage would seem to require that interest rates rise by enough to cover the inflation plus the income tax on the nominal interest, but this does not seem to happen, with the result that inflation tends to reduce the real after-tax rate of return. On the other hand, deflation of 2% would provide a real after-tax return of 2%, which I think is better than most savers have seen, even in better times.

  37. Joseph

    “5% inflation halves one’s savings in 13.5 years.”
    “Only if you are stupid enough to stuff your savings under a mattress.”

    One could argue that this is a feature, not a bug. One purpose of moderate inflation is to encourage capital investment rather than hoarding of cash and treasuries.
    “In my experience, inflation tends to reduce the real after-tax return to savings.”
    This is really only an issue for the 1%, those who have maxed out their tax-advantaged retirement accounts and have a substantial amount of their savings in taxable accounts. Even for the 1% there are alternatives like tax-exempt muni bonds or a portfolio strategy of holding all of their taxable bonds in tax-advantaged accounts and their more tax efficient equities in their taxable account.

  38. flow5

    The FED’s technical staff should learn the differences between financial intermediaries and commercial banks. The FED KILLED the money market.

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