Yet another economic writer has caved into the illusion that central banks need to raise the inflation target to four percent.
In 2010, Olivier Blanchard, the former chief economist at the International Monetary Fund, offered reasons for a higher inflation target.
Wall Street Journal’s chief economics commentator Greg Ip was against the idea them, but suddenly had a change of tune. “Events have weakened the rationale against the current two percent target”, says Greg Ip.
Please consider The Case for Raising the Fed’s Inflation Target by Greg Ip.
Six years ago, Olivier Blanchard, then chief economist at the International Monetary Fund, floated the idea that central banks should target 4% inflation instead of 2%. I remember giving a colleague countless reasons why he was wrong.
It was I who was wrong. Events since 2010 have led me to conclude those objections no longer apply. The Federal Reserve should give serious consideration to raising its inflation target. Here are my original objections and how they have changed.
Wrong Then, Even Wronger Now
1. Ip Then: Central banks have invested their credibility in a 2% target. If they raise it, the public will assume they’ll raise it again, and expectations will rapidly become unanchored.
1. Ip Now: The fact that inflation has actually drifted lower despite repeated doses of unconventional monetary stimulus shows that inflation is quite inertial and not easily dislodged by questions of credibility. If anything, central banks are too credible: Investors seem to believe 2% is a ceiling, not a midpoint.
1. Mish: Inflation expectations were a joke then. They remain a joke now. Pray tell what consumers give a damn about expectations? Is the average Joe on the street concerned about “expectations” or “reality”. What’s become “unanchored” is Greg Ip’s thought process.
2. Ip Then. As inflation rises, individual prices become more volatile, which makes the economy less efficient and more prone to booms and busts.
2. Ip Now: This is still true, but against that we can see the harm from not being able to lower real (inflation-adjusted) rates further is much larger than anticipated. Meanwhile, the microeconomic harm of higher inflation is elusive. The National Bureau of Economic Research recently published a paper by Emi Nakamura, Jón Steinsson, Patrick Sun and Daniel Villar that found prices did not become more dispersed during the Great Inflation of the late 1970s and early 1980s.
2. Mish: The damage from higher inflation is 100% given if one knows how to measure it. Supposedly there was little inflation in 2007. In reality, inflation was massive. The measured inflation in 2007 ignored asset bubbles. The measured inflation today ignores asset bubbles. Only fools do not see the asset bubbles this Fed has created. They are so obvious that even some Fed presidents see them. History suggests that by the time central bankers see asset bubbles, the damage has already been done.
3. Ip Then: Since inflation is below 2% now and there are no new tools to get it higher, it will undermine central banks’ credibility to raise the target.
3. Ip Now: Japan’s success in getting inflation back above zero, albeit not to 2%, suggests adopting a higher inflation target can bring a shift in expectations, and actions, that help make it happen.
3. Mish: Japan’s “success” if one is foolish enough to label currency destruction as a success, does not have anything to do with expectations. Japan could set an expectation of 20% tomorrow and it would not do a damn thing. Japan’s success stems from actions, not expectations. The market clearly demands more action now. Expectations are meaningless.
4. Ip Then: A higher inflation target makes real interest rates more negative, which would spur reach-for-yield and other speculative excesses.
4. Ip Now: This is true but the alternative may be worse. Rates have been at zero for so long because central banks are erring on the side of monetary ease; they fear that premature tightening will tank the economy and rates will get stuck at zero again. This would be less likely with a higher inflation target, so central banks may not leave rates so low for so long. They would also have less need for quantitative easing and other unconventional tools, which bring their own risks.
4. Mish: Supposedly setting higher inflation targets cause higher inflation. How long has the ECB and Bank of Japan had a 2% target. Meanwhile, damn the asset bubbles. Full speed ahead.
5. Ip Then: What happened in 2008 was unique. Why change the target for something that happens maybe twice per century?
5. Ip Now: Interest rates have been near zero now for more than seven years, and there is every reason to think similar episodes are going to happen again. This was the essence of Mr. Williams’s argument. He isn’t proposing a higher target (or a nominal gross domestic product target, which serves the same purpose) because he’s worried about the economy now. In fact, he is optimistic enough to think the Fed should proceed with another rate increase before long.
5. Mish: Brilliant!
Greg, what mind altering drugs are you taking?
Mike “Mish” Shedlock