Today, we present a guest post written by Jeffrey Frankel, Harpel Professor at Harvard’s Kennedy School of Government, and formerly a member of the White House Council of Economic Advisers. A shorter version appeared in Project Syndicate on July 25th.
The Fed has some reasons for cutting interest rates at its meeting July 31, or subsequently, if the US economy weakens. (And there are some good arguments on the other side as well, if growth remains as strong as it has been over the last year.) But I find less persuasive one argument for easing: a perceived imperative to get inflation up to 2.0% or higher.
Federal Reserve Chairman Ben Bernanke set a 2% target for the US inflation rate in January 2012. Some other countries had already done the same. Japan followed suit a year later. Indeed Shinzo Abe’s successful accession to prime minister in late 2012 was predicated on the promise that monetary policy would raise inflation (Japan having previously suffered from negative inflation).
The case for trying to raise expected inflation
The logic was impeccable. With unemployment still high and growth still low in the aftermath of the 2008 Global Financial Crisis, some further stimulus was called for. But the nominal interest rate had already been pushed virtually to zero and could not be pushed much lower. Raising expected inflation could be a way to stimulate economic activity. An increase in the expected inflation rate would lower the real interest rate (which is defined as the nominal interest rate minus expected inflation). Making it cheaper to borrow in real terms would persuade households and firms to go out and buy more cars, buildings, and equipment. After all, the decision to build a house is more attractive if the value of the house and the rental rate are expected to rise.
But how were the monetary authorities to achieve the desired increase in expected inflation among the public? By announcing that their objective was to raise inflation to 2%, or higher; by being sincere in that announcement; and by keeping the foot on the monetary accelerator pedal (particularly via quantitative easing), so long as inflation had not yet reached 2%. The central banks did these things, increasing their monetary base many-fold. They did not lack sincerity. It is hard to see what more they could have done.
Did it work?
Did the plan work? It did, and it didn’t. It didn’t work, in the sense that neither in the US nor Japan, nor in the eurozone, has inflation yet attained 2 percent. The core US PCE deflator has been running at 1.7 % per annum lately. Japan’s inflation rate is stuck below 1.0%. Month after month, year after year, the authorities have had to explain that it was taking a bit longer to achieve the target than they anticipated. Standard measures of expected future inflation, such as from professional forecasters, remain below 2 % as well.
Meanwhile, however, the two economies returned to approximate full employment by 2016. US unemployment has lately fallen to 3.7 per cent (down from almost 10 per cent in 2009-10), its lowest level in 50 years. Japan’s unemployment is at 2.4%, down from over 5% in 2010. It is past time to declare victory.
Most monetary economists and central bankers, however, remain hung up on the need to deliver that 2% inflation target. They worry that their credibility is at stake. Some economists want to re-assert the target with renewed clarity. Some even want to raise the target from 2% to 4 per cent. One proposal that is popular among monetary economists is called price level targeting: the Fed would promise to achieve future inflation that is 1% above the 2% goal, for every year that it has already fallen short of that promised goal.
But why should these more ambitious commitments be credible or achievable after the simple 2 per cent target has been seen to fail?
Where to find an analogy? A sheriff draws his gun on a bank-robber, swearing that he will pull the trigger if the suspect does not surrender. He pulls the trigger, but the gun fails to fire. At the same time, the robber is run over by the deputy. Rather than declaring victory, the sheriff proclaims that the credibility of his threat is at stake and so, standing over the dead body, continues to pull the trigger and continues to draw blanks. Such strange behavior neither advances the cause of justice in the case at hand nor contributes to the sheriff’s long-term credibility.
Why did the expected inflation bullet not fire? Perhaps expected inflation — so central a part of economists’ models ever since 1968 — doesn’t really exist. To be more precise, the public’s expected inflation rate may not be a well-defined number in normal times of relative price stability. In a country like Argentina where the inflation rate is still high, households and firms find it worth their while to keep track of it. But most people pay little attention to the inflation rate, when it is running at levels as low as it has been.
Perhaps “expected inflation” doesn’t exist
A recent paper by Olivier Coibion, Yuriy Gorodnichenko, Saten Kumar, and Mathieu Pedemonte, “Inflation Expectations as a Policy Tool?”, marshals an impressive amount of evidence that undermines the notion that households and firms have well-informed expectations of future inflation, or that they even know what the inflation rate has been in the recent past.
Among the findings they present:
- “Large policy change announcements in the U.K., U.S. and eurozone, such as the declaration of the 2% inflation target, seem to have only limited effects on the beliefs of households and firms.”
- US “household expectations have averaged around 3.5% since the early 2000s.” This is well above the actual inflation rate, and also well above what professional forecasters and financial market participants were forecasting.
- “Hundreds of top executives were asked to report their point forecasts for CPI inflation over the next twelve months. 55% reported that they simply did not know. Of the remaining respondents, the average forecast was 3.7%,” which is again too high.
- Respondents were similarly far off internationally, according to studies in Germany, other euro countries and New Zealand.
- US households get little information when they read news coverage of FOMC meetings.
- The standard measures of expected inflation are designed in ways that can give misleadingly sensible answers. For example, some standard surveys of public inflation expectations effectively suppress wild answers by “priming” the respondents with a set of reasonable choices (“less than 1%”, “between 1% and 2%”, “between 2% and 3%”, and “above 3%”).
- To be sure, the authors interpret some evidence as showing “a causal and economically significant effect of inflation expectations on the economic choices of both households and firms.” But the direction of the estimated effect is ambiguous.
Why keep hitting your head against the wall?
If it is not worth the trouble for average people to formulate well-informed forecasts of inflation, that It is not a cause for concern. In fact, it reflects that effective price stability has been achieved. As was noted at a Brookings Conference last year,
“Fed Chairman Alan Greenspan once defined price stability as ‘that state in which expected changes in the general price level do not effectively alter business and household decisions.’ In other words, price stability is when inflation is low enough that people don’t think about changing prices in their daily economic lives.”
Why then should central bankers keep hitting their heads against the wall of the 2% target? To be sure, it is good for the monetary authorities to be transparent about what they expect inflation to be in the long term, as with the real growth rate and the unemployment rate. And for that purpose there is nothing wrong with 2%. However – and this is a radical suggestion — perhaps it is time for the Fed and other central banks, rather than doubling down on their oft-missed 2% inflation target, to quietly stop actively pursuing it in the medium term.
This post written by Jeffrey Frankel.
This is a thoughtful paper on the difficulties of monetary policy. A lot more thoughtful that the recent calls for a return to a gold standard. Over at Econospeak, I noted something by John Cochrane who did a nice job of saying what a gold or even a commodity standard would be a mistake. But also Cochrane went on record on why we need to LOWER the target inflation rate to zero. Obviously I disagreed and I should note a recent post over at Angrybear who is calling for a higher inflation target for reasons this post notes.
Good post. But it might be useful to remember how the whole 2 percent target thing came about. It started with the New Zealand central bank adopting it for no clear reason about 30 years ago. Then in the mid-90s as Greenspan began to realize he did not want to take the punchbowl away as growth boomed and inflation did nothing, even as the officially estimated NAIRU was getting passed, and he had had a view of zero inflation as the goal to preserve nominally fixed income streams, then Fed Gov Janet Yellen got to him with a paper by her hubbby, George Akerlof with Dickens and Perry. They provided a micro behavioral argument for at least having a low while positive target, with 2 percent as maybe about right, although not set in concrete.
Their micro efficiency argument was based on the behavioral reality of the downward stickiness of nominal wages and the need for real variations in relative wages across sectors. Of course this all depends on the rate of labor productivity growth, but if it is not great enough then to get intersectoral real relative wage changes one must except some substantial upward movement of nominal wages in growing sectors, with price hikes likely to follow. So, some inflation needed to carry this out. Maybe 1 percent would be enough, but 2 percent definitely puts one on the safe side, maybe. And, hey, the kiwis did it, so… Anyway, Yellen got Greenspan off zero, and he did not take away the punchbowl, and 2 percent became the de facto target, even if it was not officially accepted until much later, Greenspan always opposing any official target.
Well yeah, the 90s occurred when the LBJ/Nixon era money printing to keep deficits low if not flat finally ran out of the money supply. Keeping 0% inflation target was probably felt to give central banks leeway to attack debt bubbles.
You make some really dumb comments but this one takes the cake.
It is what it is. Between 1965-73 the US instead of running huge deficits, printed money to cover the cost and that kept deficits low. Its also very clear, actual “money printing” inflates the money supply so much compared to deficits. History is on my side. Not yours.
#1 – the increase in tax revenues from inflationary finance in the U.S. has never been particular high even when inflation hits the levels of 1965-1973. Yes – we had that temporary spike in defense spending during Vietnam but traditional tax revenues as a share of GDP was also high. This particular comment of yours shows you have no clue what the basic data even is. But do go back to writing intellectual garbage for Lou Dobbs!
That’s a nice summary, Barkley. I think most of us accepted the sticky prices rationale for 2% inflation, that is, a degree of inflation was helpful in wiping out contractual mistakes made earlier. On the other hand, 2% inflation was not a lot, so even ten years later prices were not unrecognizable.
The issue again is why inflation — and interest rates — are so low. Frankel intimates that something has changed, but he doesn’t really tell us what. This comes back to the whole demographics argument. If you’re in the macro business today, I don’t think you can avoid intellectual engagement on that issue. In this world, for example, US unemployment at 3.7 percent, its lowest level in 50 years; and Japan’s unemployment at 2.4%, is not coincidental, it’s causal. If you’re chronically short on labor, then unemployment rates will be low, particularly with a rising dependency factor. That is, when people retire, they leave the productive workforce, but do not exit as consumers. So there’s lots of demand (but little growth in it) meeting a dwindling supply of labor. Low interest and inflation rates, in this world, are the flip side of low unemployment. They are part of the same phenomena.
Steven Kopits: Yes, see Eggertson and Mehrotra, which I discussed back in 2014 on this blog. You commented (on other aspects, not secular stagnation).
Not sure what you mean here, but I don’t mean secular stagnation.
E&M write: “This idea was termed the ”secular stagnation” hypothesis. One of the main driving forces of secular stagnation, according to Hansen, was a decline in the population birth rate and an oversupply of savings that was suppressing aggregate demand.”
With US unemployment at fifty year lows, it’s hard to argue there’s a lack of aggregate demand. It’s easier to argue that the economy is over potential GDP than under it. Indeed, that’s what the CBO shows on Figure 2-8 in the “Data Underlying Figures” spreadsheet linked below, which underpins the CBO’s January 2019 report The Budget and Economic Outlook: 2019 to 2029. The CBO expects the economy continues to operate above potential GDP through 2021.
Furthermore, in my world, productivity growth per worker is not necessarily off the long-term trend. Having said that, TFP has substantially under-performed CBO expectations, which you can see on tab ‘Box 2-2 Figure’. The numbers really begin to diverge from expectations in 2011. That could be considered ‘secular stagnation’, but is it? What’s special about 2011?
Well, in 2012, the 65+ age group starts growing faster than the 20-64 age group for the first time. In 2018, the older group was growing faster than the younger group by 1 million per year, and this increases an annual differential of 1.5 million in the mid-2020s, as we can see on tab Figure 1-5. That means the Service Ratio, workers to retirees, is dropping after 2011. We tend to think of this as a dependency ratio, but it has another interpretation. When people retire, they don’t leave the market as consumers, although the consumption drops by 1/3, I think. (Slugs, you want to dig up the right number?)
This implies a shortage economy with respect to labor, that is, demand is growing faster than supply due to intra-population effects (ie, people are changing classes in the economy — worker to retiree) without necessarily changing aggregate population numbers that much. This then shows up in the unemployment rate, current a historically low 3.7%. In Figure 2-9, the CBO sees the unemployment rate at 3.6% for 2018-2019, but then the rate moves up again, averaging 4.7% from 2021 to 2029. Nevertheless, if you take the logic of the Service Ratio, then unemployment will continue to move down. I personally would not be surprised to see it in the low 3%s in the 2020s (leaving aside the question of a recession for the moment), which suggests the CBOs forecast is too pessimistic by maybe 1.0-1.5 pp wrt to unemployment.
So from my perspective, it’s a supply, not an aggregate demand, story.
Data Underlying Figures
https://www.cbo.gov/publication/54918
We downinder adopted a 1-3% target BUT on an underlying basis over the business cycle.
A target of 2% inflation is too low in terms of secular stagnation.
Central Banks have little ability to create inflation unlike what Friedman thought. Structural issues are far larger. Unemployment rates aren’t great tools either. They are driven by political dynamics and demographic changes, leading toward different calculations in different eras.
The icing on your earlier cake. C’mon man – stop with this dumb comments.
It is what it is again, you need to stop following SOP. The Fed can effect cost of money, but that is the end of it. When capital is over abundant, its cost will be low thus the Fed is irrelevant.
WHATEVER!
Dear Folks,
I don’t disagree with the argument made by Professor Frankel, and I do oppose the interest rate cut that seems inevitable. If interest rates have to rise later, the cut will make the rise cost more.
And no, I don’t agree with “The Rage” that the Federal Reserve ran out of money. A much more plausible case would be that wage increases of the 1960s and at least the early 1970s were ratified by the Federal Reserve, and the wage increases and price increases that accompanied them happened because of a multitude of things. The war in Vietnam, and the refusal of the U.S. government to try to delay construction spending so that the buildup in Vietnam could happen on schedule, was one. But an argument I have made in print with Fred Joutz in “Energy Economics” looks to “Technology and Transformation in the American Electric Utility Industry”, by Richard Hirsh, who goes into detail on the productivity slowdown in the 1960s, which the Federal Reserve had no control over.
But it is possible to side with the critical view that the unformed view of inflation is an effect of the low inflation rates that have existed over the past few years, and that it may not last. My own feeling is that the formation of inflation expectations has been seriously under-studied by the economists, who have debated over rational vs. adaptive expectations without making the same effort to understand surveys of actual inflation expectations.
Julian
Julian Silk I remember reading something that looked at inflation expectations by generational cohort. People tend to put a lot of weight on what inflation was when they were in early adulthood. This might explain why so many aging baby boomers tend to believe stuff they read in shadowstats and why they are suckers for Glenn Beck’s gold deals. Or why poster “Ricardo” saw Zimbabwe in every Fed rate cut.
Also, something I’ve noticed is that most people don’t think in terms of rates of change, but tend to think in terms of accumulating rates of change. For example, when people think about violent crime, they don’t reset their memory to zero every January 1st and then 365 days later compare the number of violent crimes that occurred over the last year with the number of crimes that occurred over the previous year. Instead, they tend to remember things in terms of the accumulating number of violent crimes that they remember going back many years. So we see Donald Trump still living in the “Death Wish” crime era of the 1970s even though violent crime is at a 60 year low. I don’t think this is unrelated to many people’s inability to distinguish between stock variables and flow variables. Our brains are not hardwired to think in terms of rates of change. Evolution made us creatures who accumulate experiences and remember those without a temporal reference. That’s a useful skill out on the savannah, but not so useful in a modern economy.
This is an important discussion. Too bad it’s way out of my league, but I would add a couple of thoughts…for what they’re worth:
(1) I don’t entirely agree with Prof. Frankel’s comment that there is no theoretical support for a 2 percent target. Now it may well be the case that how we arrived at the 2 percent target was an historical accident, but I remember reading some NBER paper a few years ago that laid out a theoretical argument for a 2 percent target rather than a 4 percent target. I don’t mean to suggest that the NBER paper wasn’t without it’s problems or that I agreed with it, only that the 2 percent target does have some theoretical support…or rather, that it has supporters who advance theoretical arguments.
(2) When I look at OECD data it appears that inflation has been ticking up. For example, OECD-Europe in 2017 (the most recent data) is 2.49 percent. Inflation for the G20 countries was 2.32 percent for 2017. And the United Kingdom doesn’t seem to have any problems with chronically low inflation. In fact, I would assume that Boris Johnson and Brexit will remove any concerns about low inflation.
https://data.oecd.org/price/inflation-cpi.htm
(3) Would a higher inflation target be more achievable if the central banks cooperated more? In other words, get the Germans on board with higher inflation.
(4) As I recall, Krugman always pointed out that the central bank had to credibly promise to be irresponsible in order to get out of the “Jap Trap”
https://web.mit.edu/krugman/www/japtrap.html
So maybe Trump’s nomination of Judy Shelton makes some kind of perverse sense. She certainly seems irresponsible.
Yep. There are calculation costs – so if inflation is low, e.g, 2% – people just pay attention to other things. Like trying to figure out what all the buttons do on new cars.
This is a serious point and the reason Garber and I used German hyperinflation data to test theories about endogenous regime switching and bubbles.
Question of costs and benefits. Having a substantial inflation rate allows central banks more counter-cyclical power, but in a disinflationary environment, maintaining (or re-establishing) an inflation rate well above zero takes much more expansive monetary policy. Some channels seem to be blocked, in particular the wage channel. That means most of the impact is through channels that still work, like the asset price channel. The asset price channel is where one cost comes in. Another cost is central bank credibility, to the extent that matters. If the public does not actually reckon much with the central bank when setting inflation expectations, there may not be much cost in terms of credibility loss in failing to reach an inflation target.
Nothing new in the first paragraph. Thing is, there is a potential benefit to “try, try again” if because higher inflation may someday be attained. Central banks, the Fed in particular, imposed massive costs on the public to defeat inflation. Was Volcker wrong to do that? Are the costs of defeating disinflation so high that we cannot face them? We don’t know that 2% ( or higher) inflation cannot be engineered. We only sort of think maybe it can’t be, or that doing so might be hard or risky.
Of course, toss in well-designed fiscal policy and monetary policymakers wouldn’t need to take big risks to beat disinflation. We’d be able to moderate cyclical swings even in a disinflationary setting.
I do not think that central banks were shooting blanks so much as they were too cautious, trying to avoid creating too much inflation. The US FOMC in particular has treated the 2% inflation goal more as a ceiling, and now here they are about to cut rates at full employment. Not too long ago (6 months ago) they were telling us that rates would rise several times this year. Epic U-turn!
If the Japanese Central Bank decided to retire a substantial portion of the debt (about 200% of GDP), with a permanent money infusion, does anyone doubt that some serious inflation would ensue? It is not that they cannot create inflation: it is more like they are afraid of the consequences if they use bigger tools like permanent retirement of debt with money.
Which brings me to … if the Fed is going to stop targeting 2% inflation, what is the new policy goal? Cue Scott Sumner and Nominal Income Targeting I guess…
From a consumer’s perspective, low unemployment and low inflation are positives… unless they are also debtors whose income can be pegged to inflations plus some margin in which case inflation makes my debt cheaper. The flip side of that is if I’m a lender, then my money may be eroded if the inflation rate approaches the interest rate at which I lent the money.
I’ve always thought that a “healthy” economy was one with relatively low, stable inflations where overall growth was driven by productivity and greater sales volumes. So, 2% looks better to me than 8%.
Someone should clue you in on something Irving Fisher wrote 112 years ago. You seem to think that higher inflation lowers the real cost of borrowing as if higher expected inflation has no impact on nominal interest rates. We may have to apologize to CoRev for suggesting he has zero knowledge of economics. Even CoRev gets the Fisher effect but not Bruce “no relationship to Robert” Hall!
Inflation (unanticipated) would help erode debt, which is at very high levels, both public and private. The Fed is facing the next cyclical downturn not only with little room to lower rates, but with a bloated balance sheet. My own guess is that today’s scene with low unemployment and low inflation will be fond memories in the not-too-distant future, as policy makers try to fight high rates in both places simultaneously. I think discouraging higher debt levels and further asset price inflation are more important goals for monetary policy now than trying to foster inflation.
“Inflation (unanticipated) would help erode debt”.
Yes unanticipated inflation may reduce real interest rates – a point that completely alludes Bruce “no relationship to Robert” Hall but ever heard of rational expectations. If the FED decide to raise its target inflation rate from 2% to 5%, something tells me that market participants would get this which would raise nominal interest rates by 3%. So according to the Fisher effect, there is no change in real rates. But shhhh – don’t tell Bruce “no relationship to Robert” Hall as this might get him all angry again!
I buy lots of my clothes atGoodwill. Prices doubled on 2011, and doubled again by 2017. Please don’t give me your money”inflation”. You are selling s*** Sammie he’s aged I ain’t buyin your c***. F*** “new economics’ men. Harvard blows H2Sulfide. edited MDC]
“marshals an impressive amount of evidence that undermines the notion that households and firms have well-informed expectations of future inflation, or that they even know what the inflation rate has been in the recent past.”
i believe this to be true. in reality, i do not think anybody on this board, as a consumer, significantly changes their spending patterns based on inflation. the only catch would be if inflation is extremely high-probably much higher than 10%. the only items which may be influenced by this are homes, but the large rental options help alleviate this a bit. some may argue cars, but you buy a car because yours is old and you need a newer one, not really because of interest rates. while i follow interest rates and inflation, and try to use this information for better investments and purchasing options, in reality i have yet to see where it has had much of an impact on my actions. this argument applies to consumers, and probably to the many smaller businesses out there. maybe larger corporation with financial offices behave a little bit differently?
The analogy is almost exactly wrong. The sheriff did not pull the trigger. QE was dialed back and ST interest rates were INCREASED while average inflation was below 2%.