Topic 2: Should the inflation target be raised?

Lecture to 3rd year undergrad ‘Current Economic Problems’, Bristol, Spring 2015

Tony Yates

Overview and motivation

• Blanchard et al (2010)/Krugman (various):– Inflation target needs to be higher to reduce

frequency and severity of visits to the zero lower bound to interest rates.

• What is the zero bound?• Case for monetary stabilisation policy and how

it’s normally conducted

Taylor Rule and the intellectual background to interest rate stabilisation

it it 1 c t T yyt yn

‘positive’: Taylor (1993) discovered that this rule fit past Fed policy well.

‘normative’: Work by many others showed that rules of this form do a good job at stabilising inflation and the output gap

Woodford and others made the intellectual connection between stabilising these things and welfare of the representative agent.

Rules ‘operationalised’ / improved by inserting forecasts/lags instead of contemporaneous terms.

If there is a boom, raise rates, and vice-versa.

Inflation target and the room for cutting

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Great moderation

0 5 10 15 20 25 30-4

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Secular stagnation

Two stylised central banks responding to fluctuations in the business cycle with policy rates.

Lower inflation target means lower average nominal interest rates, which prevents rates from tracing out the bottom of the sine wave necessary to smooth the troughs.

Issues

• Why does the average nominal interest rate depend on the inflation target?

• How does the zero bound arise and is it really zero?• Post-crisis lesson about the amplitude of the typical cycle• Post-crisis lesson about equilibrium real rates• Are there alternatives to interest rate stabilisation?• What are the costs of incomplete stabilisation?• What are the costs of inflation that offset benefits of such a

rise?• Are there risks to credibility of raising the target?• Is this cure or prevention?

THE FISHER RELATION

How raising the target helps through the Fisher relation

i c T r

it it 1 c t T yyt yn

If we calculate ‘steady state’, or ‘long run average when all shocks cancel out’ of an economy following a Taylor Rule, then we will find this:

This is the Fisher Relation.Investors in the LR will demand compensation in the interest rate to protect real value of their investment against inflation.So ir rises one-for-one with the inflation target and real rates

THE ORIGINS OF THE ZERO BOUND TO CENTRAL BANK NOMINAL INTEREST RATES

Money demand and the zero bound

•Marginal liquidity services value of xtra unit of real balances declines as liquidity increases. •To persuade people to hold larger real balances, opportunity cost [the nominal interest rate] has to fall.•No different from Mars Bar demand, where in price falls as you try to persuade someone sated with Mars Bars to buy another.•Zero bound arises because cash, which earns zero interest, dominates any –ve interest rate investment•At the zero bound, OMOs involve the swap of one zero interest, default risk-free asset for another

Zero bound

• From time to time rule dictates less than zero interest rates.

• Yet: no-one can offer a negative interest rate on an investment when an investor can earn zero interest on cash instead.

• Central bank deposit rate<0: no one will deposit.

• Central bank lending rate <0: a giveaway with no impact on market rates.

But is the ZLB really zero?

• What is the asymptote of the marginal liquidity services value of real balances?!

• More simply: at some point, have we got enough, and does more become inconvenient and actually costly?

• If ‘yes’, then rates can become negative.• Hence not surprising we have seen some cbs

like Denmark, Switzerland able to cut rates to <0.

Overcoming the ZLB

• Idea pushed by Gessel, Buiter, Kimball and others.– Flows from analysis of origins of the zero bound.– tax cash. People will lend at negative rates, then.– Abolish cash: tax electronic currency.– Some argue that cash anachronistic and benefits

crime.– Dismissed on grounds of radicalism.

SECULAR STAGNATION AND THE EQ’M REAL INTEREST RATE

Secular stagnation

• Coined by Alvin Hansen in 1938 at AEA, talking about pessemistic view of the supply side.

• Low rate of technical progress in the future.• Demand side view argues that other forces

press down on equilibrium real rates, and therefore average nominal rates.

Middle-aged people [like me] save for their old age. And increasingly so now as state pension entitlements more uncertain than before. Pushes down on real rates.

Cheaper capital goods means firms don’t need to borrow so much to finance capital accumulation. So demand for savings falls, pushing downward pressure on real rates.

Large flow of savings ‘uphill’ from growing emerging economies, mirrored by borrowing of the already rich countries. Pushes down real rates.

Not just private saving in the Emerging markets either, public accumulation of reserves too.

Crisis destroys safe assets

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• Crisis destroys safe assets, eg:

• ABS markets close

• Corporate bonds lose their apparent safety

• Recovery/re-opening in many markets, but some impairment persisted

Result: real rates decline

‘Secular stagnation’=lower eqm real rate

it it 1 c S t T yyt yn

Many pressures pushing down on the equilibrium real rate, and therefore on central bank interest rates.

i c S T r S

To keep i-star at old level, and preserve old frequency of zlb episodes, need to raise inflation target to offset the effect of lower real rates on the constant anchoring i.

POST-CRISIS LESSON ABOUT THE AMPLITUDE OF THE TYPICAL BUSINESS CYCLE

Pre-crisis intellectual euphoria

• 60s-early 80s ‘The great inflation’.• 80s-late 2000s ‘The great moderation’.• Macro and financial policy problems supposedly

solved by inflation targeting, independent central banks, and Nkeynesian macro.

• Monetary policy potent due to careful management of expectations.

• No more inflation scares or financial crises.

Post-crisis

• Large, financial-crisis-induced recessions possible.

• Great moderation more due to good luck than we thought.

• Need for large interest rate cuts much greater than we thought.

• Estimates were of desired rate cuts of 5-10pp at peak of crisis.

ALTERNATIVES TO INTEREST RATE STABILISATION

Alternatives to interest rate policy

• Quantitative easing– Central bank buys MT/LT maturity bonds

• Forward guidance– Manipulate future rates, if current rates at ZLB

• Credit easing– Buy private sector securities

• Conventional fiscal policy: automatic stabilisers and discretionary fiscal policy

• QE: consensus from event studies that it lowered yields on impact. But effect still uncertain. May also be costs.

• FG: relies heavily on sophisticated forward-looking behaviour and careful expectations mgt by and credibility of cbs.

• CE: tried, but involves risks too.• FP: political constraints eg US/UK.

COSTS OF INCOMPLETE STABILISATION

Consequences of inadequate monetary stabilisation

• (Risk of) Larger busts.• (Risk of) deflation

– Nominal debt-deflation spiral– ‘Postponing consumption trap’– Menu costs…

• In extremis: Risk of trapping interest rates at the zero bound permanently [eg Japan?] entering a true ‘liquidity trap’

• RBC view is that business cycles are efficient.• Monetary policy may not be the appropriate tool

for some fluctuations caused by real distortions.• Lucas-calculation that micro evidence of risk-

aversion+rep agent model means costs of cycles is very small.

• Heterogeneous agent models: for those who bear costs of cycles (the poor), costs are very large.

COSTS OF INFLATION

The tragedy and the bliss of the zero bound

• At the zero bound, if it exists, we have squeezed the marginal reduction in transactions costs associated with holding money to zero. This is good. This is the Friedman Rule.

• But, we have also run out of room to use interest rates to counter-act negative shocks to the natural rate of interest.

Friedman Rule

i c T r

i 0 T r

r 0 T 0

At the Friedman Rule, with interest rates 0 in the long run, the inflation target equals minus the real interest rate.

Prices fall at a rate equal to the real interest rate. ie Deflation!

Logic: set the inflation rate so that the real returns to holding money are the same as those to holding a real asset.

That way there is no penalty to holding money, and the transactional/liquidity benefits can be maximised.

Money demand and the zero bound

Zero bound maximises holdings of real balances, and maximises social benefits of holding them.Up to this point, the marginal benefit of holding real balances is still positive.Since there is no social cost of producing them, [money is practically free to create] then why impose one via R?

Menu costs and relative price uncertainty

• Prices change infrequently because it is costly to change them continuously. Eg reprinting menus.

• While they are fixed, other prices moving because of inflation creates unwanted relative price changes and misallocations of demand.

CURE OR PREVENTION?

Implementing an inflation target rise

Taylor rule dictates that in the short run, interest rates will FALL if we raise the target [the RHS falls when target increases by B (for ‘Blanchard’)].

Even though in the long run, once new inflation target is achieved This is the Fisher Relation.Investors in the LR will demand compensation in the interest rate to protect real value of their investment against inflation.So ir rises one-for-one with the inflation target.

it it 1 c t T B yyt yn

i c T B r

Implementing Blanchard’s inflation target increase

• Since interest rates have to fall, other things equal….

• Raising the inflation target won’t increase inflation if rates are stuck at the zero bound

• Unless you believe in efficacy of alternative policies, or inflation expectations increase ‘by magic’.

• Assertion: preventative policy for the future, otherwise risk setting central bank up to fail.

CREDIBILITY ISSUES WITH RAISING THE TARGET

Credibility problems with raising the target

• Comes after a long period of inflation > target, + may look like ex-post locking in.

• Raise suspicion that every time there is a problem, inflation target will be raised.

• Whole point of target was to eradicate the suspicion that inflation target would be used for electoral/political/real-debt-reduction means.

• Already had index changes that moved the goal-posts.• UK regime is delicate and discretionary as it is. [Target can be

changed every year]• Some other cbs set their own target, so setting their own moving

target problematic.• Imprecise ‘slippery slope’ arguments.

But!

• Credibility cuts both ways.• Cost of episodically failing to meet your target

because of the ZLB creates reputation for incompetence.

• Over time, legitimacy of monetary framework may erode if it is not seen to learn lessons of crisis.

• Losing legitimacy is first step to losing control, and all the good aspects (like instrument independence) of the monetary framework.

Recap

• Lower eqm real rates, greater amplitude of cycles: we will hit ZLB more than we thought.

• So raise target.• Not now, as no instrument. It’s prevention, not

a cure.• Costs of a little more inflation moderate.• Alternative instruments tried, but still

uncertain, or unwieldy, and haven’t averted 6 year stay at the ZLB.

Recap ctd

• Risks to credibility, but they cut both ways. Leaving the framework as it is may be risky too.