Should we accept lower than 2% inflation?
Here’s Scott Mather in the Financial Times:
Central banks around the world are pivoting toward easier monetary policy. In pursuit of a 2 per cent target for inflation, major central banks seem willing to exhaust their monetary policy ammunition at a time when economic output is at — or above — potential.
In fact, monetary stimulus does not exhaust ammunition, it adds to ammunition by raising the equilibrium interest rate.
Unfortunately, there is little evidence to suggest that lower policy rates are successfully generating either better real growth outcomes or higher inflation.
That comment may reflect the fact that lower growth and lower inflation cause lower interest rates. So the correlations are not what one might expect. Nonetheless, Mather worries about the effect of low interest rates:
In some countries, this policy stance has the potential to reduce monetary policy effectiveness, create imbalances that may sow the seeds for the next crisis, and leave central banks powerless to respond to that crisis. It is time to ask whether the 2 per cent inflation target has outlived its usefulness.
But is lowflation really that bad:
Although economic recessions are typically accompanied by disinflationary forces, it is far from clear that disinflation or small negative rates of deflation actually cause economic crises. Japan has had such an environment for much of the past two decades, but its real economic growth per capita looks very similar to that of the US or Europe over the same time period.
One result of this Japanese low inflation policy is extremely low interest rates. But Mather seems to be suggesting that low interest rates are a problem, which can lead to financial excesses. So would higher rates be better? And if so, don’t we need higher rates of inflation? Here’s Mather:
And while likely fuelling these risks and distortions, low rates are clearly not delivering targeted inflation, and they may even be having the opposite effect. It has recently been observed that low rates correlate to low inflation outcomes, perhaps because they cause inflation expectations to fall rather than rise.
This is precisely why so many New Keynesians have recently advocated raising the inflation target to 4%. A higher inflation target would allow for higher interest rates. But Mather seems to go in another direction:
The “natural” rate of inflation may fluctuate over time because of the forces of technology, globalisation, demographics and so on. With potential growth rates that are barely positive and falling in places like Europe and Japan (owing much to challenging demographics), 2 per cent may also not be the natural inflation rate for every region. If this is the case, then inflation targets should be looser, more variable over time, and differ across countries with different economic structures.
There is no “natural” rate of inflation; only real variables have natural rates. One might argue that the “optimal” rate of inflation is different in slow growth countries, but in that case the optimal rate is likely to be higher, not lower. It is fast growing countries that have very low optimal rates of inflation.
HT: Stephen Kirchner
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26. June 2019 at 12:35
In case anyone needs a laugh today.
https://www.bloomberg.com/news/articles/2019-06-26/trump-says-u-s-should-have-draghi-instead-of-powell-at-fed-helm
26. June 2019 at 12:45
This is great. Readers of the Financial Times are probably dumber for reading Mather’s article.
This:
“In fact, monetary stimulus does not exhaust ammunition, it adds to ammunition by raising the equilibrium interest rate.”
is true, important, and non-obvious.
I think SOME level of inflation (2%-3%) is healthy for sticky wage reasons. It’s not obvious to me that 3% is better than 2% (because monetary policy can still work at the ZLB), but, once you pick a target, and these expectations are built into financial instruments, falling short of that target is a boon to creditors at the expense of debtors, while exceeding the target is the reverse. The Fed has been very good for banks this decade, maybe we can throw debtors a bone. Lotta talk about student loan relief recently; exceeding the inflation target (i.e. correcting for past undershooting) would help these folks.
26. June 2019 at 14:43
Scott –
“In fact, monetary stimulus does not exhaust ammunition, it adds to ammunition by raising the equilibrium interest rate.”
Have you expanded on this anywhere, describing the argument behind this in more detail? Would be very curious, thanks!
26. June 2019 at 14:53
I agree with this post.
There is an emerging concern that commercial banks cannot be profitable in very low interest rate environments. There is not enough spread between the cost of borrowing and the returns from lending. Put another way, intermediation between short and long-term rates is not profitable (the yield curve is too flat).
For economies that depend upon the endogenous creation of money that is, commercial banks create money by lending) promote growth, this is a bona fide concern.
In the United States, we are critically dependent upon increases in commercial-bank lending (about half of which is lent to real estate) to stimulate the economy.
There is an outlook that monetary policy will become less effective, though not for the reasons mentioned in the tortured article cited.
Of course, we have the power to sidestep the whole claptrap Federal-Reserve-commercial-bank system, and go straight to helicopter drops. Ray Dalio says this is inevitable. We will see.
Signing off with a wave of my tinfoil hat!
26. June 2019 at 16:18
Cameron, The why didn’t he appoint Draghi? Yes, Trump’s always good for a laugh.
Brian and Basil, I kind of thought it was obvious. Lots of progressive economists have proposed raising the inflation rate to 4%, precisely for the purpose of adding to the Fed’s ammo by raising the equilibrium interest rate. Higher inflation means higher interest rates, and more room to cut them in recessions.
The amount of “ammo” a central bank has (in conventional terms) is the difference between the equilibrium rate and zero. Monetary stimulus raises the equilibrium rate.
26. June 2019 at 20:11
Professor,
Trump shenanigans aside, do you believe Janet Yellen would have performed better than Mr. Powell? It fells like Powell is very eager to raise rates, and reluctant to cut, even if he ends up doing so. Not long ago he thought we were on a path to 4 hikes while the market was at 1 or 2. Now the market is at 1 or 2 cuts but he seems to be downplaying the need for even 1. Is it that he doesn’t want to give Trump ammo for a trade war or is he relatively more hawkish by nature? I remember he is not a fan of QE and was/is in favor of IOR to neutralize the “inflationary” effects of QE. It feels to me his rhetoric will end up forcing the Fed to do more, while a more dovish tone could help him actually do less (rate cuts)
26. June 2019 at 21:20
Yellen did worse than Powell in NGDP terms. YoY NGDP in first half 2016 was 2.5%.
However, the pressure to “normalize” monetary policy was immense. Powell probably would have made same mistake of raising rates too early.
I don’t know if Powell is critical of QE, but we need IOR with this monetary base. I like IOR because banks did all sorts of crazy shenanigans to reduce reserves before IOR. The fragile and underregulated Eurodollars and Money Market Funds have direct relationship with avoiding reserve requirements.
26. June 2019 at 23:08
The real tell that someone doesn’t understand monetary policy is when they focus excessively on interest rates, but never even mention the natural rate. It’s not uncommon to find those same people confusing real and nominal variables. It really shouldn’t be hard for editors to reject pieces about monetary policy that are obviously ignorant.
27. June 2019 at 02:30
Is there a yield on the 10 year Treasury that is consistent with an expected 4% NGDP growth rate? I’m sure it fluctuates of course. What is it now?
27. June 2019 at 05:22
But Scott, if monetary policy can be effective at the ZLB, the “ammo” argument doesn’t make sense. The “ammo” argument is also what get us to a Fed Funds rate out of whack with the rest of the yield curve.
The Fed has been quietly reducing its portfolio, now just above 19% of GDP, lowest since Q1 2013. QE3 has been largely unwound.
I’d be OK with a 2%-3% inflation target, which is what you need to lubricate the labor market.
As I said, the more important issue IMO, from a “fairness” standpoint, is that undershooting whatever target you set hurts debtors by increasing the cost of their debt.
27. June 2019 at 06:19
“In fact, monetary stimulus does not exhaust ammunition, it adds to ammunition by raising the equilibrium interest rate.”
Could someone walk me through the logic behind this? Trying to understand from a simple supply of/demand for money perspective
27. June 2019 at 07:50
What would it take to get a “slow growth” country like the U.S. or Japan to say, 7% year over year growth? Some new host of technologies or scales of efficiency? Space exploration and engineering? It seems like we are going to be perpetually stuck in the low single digits forever.
27. June 2019 at 09:31
Rodrigo, I suppose that Powell is slightly more hawkish than Yellen, but the difference is small. I doubt things would have been much different if Yellen was in charge. People overrate the influence of the chair.
bill, Yes it fluctuates. I suspect the market now forecast below 4% NGDP growth. In the long run, I expect NGDP growth to be more like 3.5%.
Brian, When people talk about “ammo” they are referring to the ability to use conventional policy tools such as adjusting the fed funds target. I agree that the entire debate is silly, as the Fed has plenty of “unconventional” tools.
Andrew, See my response above. Maybe I need to do a post on this.
Derrick, There’s nothing we could do. But even slow growth is great. America is fabulously rich, and getting richer every year. Why do people find that depressing? Do think think faster growth will make us happier? I’m no happier than when my income was 1/4th the current level, even in real terms.
27. June 2019 at 13:29
Scott —
> “I kind of thought it was obvious. Lots of progressive economists have proposed raising the inflation rate to 4%, precisely for the purpose of adding to the Fed’s ammo by raising the equilibrium interest rate. Higher inflation means higher interest rates, and more room to cut them in recessions.”
> “The amount of “ammo” a central bank has (in conventional terms) is the difference between the equilibrium rate and zero. Monetary stimulus raises the equilibrium rate.”
Gotcha, so you’re only arguing that monetary stimulus raises the equilibrium NOMINAL interest rate, not that it raises the equilibrium REAL rate?
(Wouldn’t that require a _permanent_ increase in the inflation rate/NGDP growth?)
27. June 2019 at 19:40
Scott,
Does your answer that there’s nothing we can do to achieve 7% real growth in developed countries mean that you doubt the singularity hypothesis concerning artificial intelligence, think that resulting economic growth not be so greatly affected, or do you just have a wait and see approach?
27. June 2019 at 19:41
Or, does your answer regarding what “we can do” just mean there’s nothing we can do from a policy perspective to achieve 7% real growth?
Obviously, sustained 7% real growth would be unprecendented for a developed economy, being roughly twice what one would expect even in a very healthy economy.
28. June 2019 at 09:45
Basil, Yes, that’s right. It might boost the real rate too, but only in the short run.
Michael, I’m skeptical that AI will dramatically boost growth, but obviously I know very little about the topic. Certainly there’s little that policy can do.
29. June 2019 at 00:44
Low interest rates keep price increases at bay particularly in such a financialised corporate sector. Growth dynamics indicate a labour intensive recovery and non-augmented labour productivity grows slowly compared with TFP.
TFP, measured since 1955, is below labour productivity since 2014 – it hadn’t been so before. This is a direct consequence of unconstrained money supply.
I’d written so in my Master Thesis (not published) and also on my blog. Yet recall that the primary purpose of monetised low interest rates, at least in Europe, is to ensure the correct transmission of monetary policy; and that firms set prices, not consumers.
https://eunomicsblog.wordpress.com/2018/10/29/1118/