Counting the reasons for a higher inflation target
While Paul Krugman and Greg Mankiw both explain that inflation is no threat, allow me to follow Brad Delong by listing all the reasons I know for why the Fed's current nominal inflation target of two percent (one percent in practice) is too low.
1) To maximize long run stability, the Fed should target a long-run price level, not a long run inflation rate. This way long-run investors can be reasonably assured of a particular long-run real rate of return for any given investment paying nominal dividends. The idea is that the Fed would thereby promise to correct short-run variations in inflation leading to less long-run mis-pricing of expectations and assets. Now, since inflation of the last few years has been well below target, it would therefore help restore pre-recession expectations if the Fed were to pursue higher inflation for at least a few years.
2) A higher inflation target will reduce odds of hitting the zero lower bound in future crises and recessions, thereby reducing odds of liquidity trap situations like the one we are currently in.
3) To aid the current unusually bad economic situation by encouraging spending now while the general price level is low. This is what Krugman has often described as a "commitment to be irresponsible."
4) To accelerate deleveraging of both private and public debts, thereby aiding spending and growth in the short run (in some ways similar to 3).
5) To encourage somewhat higher nominal interest rates once the economy reaches full employment, thereby reducing the incidence of asset bubbles which can be spurred by low nominal interest rates.
6) To lessen the negative impact of rigidities in nominal wages, particularly downward rigidities. And some compelling theoretical work that fits these facts suggests a higher target (say 3 or 4 percent) would be better for long-run growth.
So, what are the downsides to a somewhat higher inflation target? I can think of a few, but I think they are rather mild. One argument in the literature is that a higher inflation rate is also more uncertain. But level and variability are different things. Point (1) is a better way to deal with uncertainty in inflation. And I also know from some dabbling I did for a class paper many years ago that, at least for the U.S., evidence of a negative uncertainty effect is extremely thin. The best argument I can think of is that by changing the inflation target to something greater than 2 percent now will hurt the Bernanke Fed's credibility given they have so vigorously defended a 2 percent target (or something less) up to this point. Thus, if the Fed changes their target now, markets may be less inclined to believe the new target going forward.
The obvious, reasonable answer to the last conundrum is for the Fed to simply lay out its rationale for changing the target. But since many have built in expectations of a lower target, the Fed would plan to implement the new target gradually, and (preferably) more explicitly. That is, they could lay out a clear goal for a long-run price level that they would like to achieve going forward. That target schedule could incorporate a gradual acceleration of inflation to the new target level. All of this would, of course, be accompanied by the usual caveats that the target would sometime miss too low and sometimes miss too high, and that other mitigating circumstance could make achieving the target more difficult at some times as compared to others.
Anyway, that's my armchair macro thought of the day...
1) To maximize long run stability, the Fed should target a long-run price level, not a long run inflation rate. This way long-run investors can be reasonably assured of a particular long-run real rate of return for any given investment paying nominal dividends. The idea is that the Fed would thereby promise to correct short-run variations in inflation leading to less long-run mis-pricing of expectations and assets. Now, since inflation of the last few years has been well below target, it would therefore help restore pre-recession expectations if the Fed were to pursue higher inflation for at least a few years.
2) A higher inflation target will reduce odds of hitting the zero lower bound in future crises and recessions, thereby reducing odds of liquidity trap situations like the one we are currently in.
3) To aid the current unusually bad economic situation by encouraging spending now while the general price level is low. This is what Krugman has often described as a "commitment to be irresponsible."
4) To accelerate deleveraging of both private and public debts, thereby aiding spending and growth in the short run (in some ways similar to 3).
5) To encourage somewhat higher nominal interest rates once the economy reaches full employment, thereby reducing the incidence of asset bubbles which can be spurred by low nominal interest rates.
6) To lessen the negative impact of rigidities in nominal wages, particularly downward rigidities. And some compelling theoretical work that fits these facts suggests a higher target (say 3 or 4 percent) would be better for long-run growth.
So, what are the downsides to a somewhat higher inflation target? I can think of a few, but I think they are rather mild. One argument in the literature is that a higher inflation rate is also more uncertain. But level and variability are different things. Point (1) is a better way to deal with uncertainty in inflation. And I also know from some dabbling I did for a class paper many years ago that, at least for the U.S., evidence of a negative uncertainty effect is extremely thin. The best argument I can think of is that by changing the inflation target to something greater than 2 percent now will hurt the Bernanke Fed's credibility given they have so vigorously defended a 2 percent target (or something less) up to this point. Thus, if the Fed changes their target now, markets may be less inclined to believe the new target going forward.
The obvious, reasonable answer to the last conundrum is for the Fed to simply lay out its rationale for changing the target. But since many have built in expectations of a lower target, the Fed would plan to implement the new target gradually, and (preferably) more explicitly. That is, they could lay out a clear goal for a long-run price level that they would like to achieve going forward. That target schedule could incorporate a gradual acceleration of inflation to the new target level. All of this would, of course, be accompanied by the usual caveats that the target would sometime miss too low and sometimes miss too high, and that other mitigating circumstance could make achieving the target more difficult at some times as compared to others.
Anyway, that's my armchair macro thought of the day...
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