Tuesday, December 10, 2013

Observations on Increasing the Fed’s Inflation Target

The U.S. economy is currently growing sluggishly and has too much unemployment. No one thinks this is a good thing. Indeed, at the IMF research conference last month, many economists expressed particular concern about the high youth unemployment rate in the U.S. and elsewhere and the negative implications of this for society.

They are right to be concerned. The question is what should be done.

One answer is given by two economists of different political stripes. They are Paul Krugman and Ken Rogoff. Krugman is clearly a liberal; he even uses that word in the title of his widely read New York Times blog – “The Conscience of a Liberal.” Rogoff’s politics are somewhat less clear; I heard him say at a seminar arranged as part of the program of the World Bank/IMF annual meetings in October that he was not political, just a scholar. However, he was an adviser to the John McCain presidential campaign in 2008.

Even though they have had disagreements, they both advocate that central banks in the current situation target a higher inflation rate than the current two percent. (For example, see here and here.)

The principal argument of some economists advocating a higher inflation target is that it is a way to achieve a negative real rate of interest (the nominal interest rate is lower than the inflation rate), given that the Fed cannot lower nominal interest rates below zero. They believe that a negative real interest rate is necessary to achieve full employment. Another reason, though this seems to be less explicitly argued, is that inflation encourages current consumption (and discourages savings). Consumers have an incentive to buy now before prices increase. The resulting increase in consumption stimulates the economy.

There are a few problems with these arguments. First, in the current period, the Federal Reserve does not seem capable of increasing inflation. It has increased its balance sheet and, hence, the monetary base to an unprecedented degree. This has not, though, translated into rapid growth of the money supply and the current inflation rate, as measured by the CPI, is less than 2 percent. (I have commented on this here, here, and here.) There is, though, concern about possible bubbles in stocks and bonds and in housing prices.

Second, assuming that the Fed could eventually produce four percent or higher inflation, the economists making the case for this seem to assume that there would not be a political reaction reflecting heightened concern among the public about the future value of their savings and their ability to generate earnings that keep up with inflation.1 In this regard, it is interesting to note that in July 1971, the CPI had risen by 4.4 percent year over year. The next month, President Richard Nixon announced wage and price controls (as well as severing the last remaining link of the dollar to gold).

The public would be right to be concerned about inflation. Monetary policy is a blunt instrument, and it is doubtful that the Fed would be able to achieve a narrow target on the inflation rate for a substantial period of time. Higher inflation also can feed upon itself, as the aftermath of the Nixon’s Administration’s experiment with wage and price controls demonstrates. If this happens, ultimately the Fed would have to slam on the brakes and generate a recession, as Paul Volcker did when he was Fed chairman. Targeting inflation is not the same as targeting a short-term interest rate, such as the fed funds rate (the rate at which banks lend to each other on an unsecured basis). Inflation is only observable with a lag, and it takes some analysis and judgment to discern whether a higher or lower than expected monthly number is due to a temporary aberration or is indicative of something more permanent.

Finally, using fiscal policy is preferable and more likely to be effective than monetary policy to stimulate the economy in a prolonged period of sluggish growth (or worse). When the Fed increases the monetary base, it does not directly add to demand. If the money is lent out by the banks, the borrowers will spend or invest it. But what if the banks sit on a huge amount of excess reserves, as they are doing now? Then nothing much happens to the real economy except for whatever stimulatory effect there is from the increase in the prices of the assets the Fed has bought (Treasury notes and bonds and mortgage backed securities).

On the other hand, if the government spends money, this directly adds to demand. In this regard, there is a strong argument that the federal government should be investing in improving infrastructure, both because infrastructure, such as highways, bridges, public transportation systems, and water and sewer systems, need to be improved and because such projects will put people to work. Krugman and Rogoff agree on this, as does Martin Feldstein, who disagrees with the other two on monetary policy. Also, if the federal government finances this by increased borrowing rather than taxes, it can borrow very cheaply since interest rates are too low. The cost in inflation-adjusted terms may even be negative, if inflation turns out to be higher than the nominal rate at which Treasury borrowed.2

The rejoinder to this argument is that it is not currently politically possible to increase government expenditures in any significant way. That is true, which is why the Fed feels it has no choice but to follow an aggressive monetary policy. Janet Yellen apparently believes that regulatory tools can be used to contain any bubbles that may develop because of this before they cause too many problems. I hope she is right, but I understand why the Fed needs to run this risk when fiscal policy has been contractionary. It is a troubling fact that the current economic distress and uncertainty have given rise to a populism of the right that believes that shrinking government in the current situation will solve economic problems rather than prolong them. It is also troubling that there is a dearth of skilled and knowledgeable politicians who can lead the public to understand the right solutions. Instead, we have a faction of the Republican Party riding the Tea Party wave for opportunistic reasons, though it is doubtful that they will reap the political benefits they hope.

While I think the Fed has no good options other than following its current course, announcing an inflation target of 4 percent would be a mistake. The risks of doing that are, I believe, higher than Krugman and Rogoff appreciate. In any case, it is doubtful that it is politically possible. While the Fed is an independent agency and insulated from the political winds of the moment, it cannot totally ignore political reality.

1. When I worked at Treasury, I was heavily involved in the discussions about and the development of Treasury inflation-indexed bonds (Treasury Inflation-Protected Securities or “TIPS”). One of the arguments made for Treasury issuing inflation-indexed bonds is that this would facilitate the private sector’s creation of other inflation-indexed products, such as inflation-indexed annuities or mortgages. There has not been much interest in other inflation-indexed products, except for mutual funds that invest in TIPS and, sometimes, physical commodities. Note, though, that, if there were greater use of inflation-indexed products, these instruments could have served to mitigate to a degree people’s fear of inflation, but at the same time they would also have acted to limit inflation’s ability to stimulate the economy.
2. Treasury does not match particular security issuances with particular expenditures. Therefore, as a practical matter, it is not possible to determine the borrowing costs for any particular expenditure without making some assumptions.

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