July 28, 2019 — The Fed has some reasons for cutting interest rates at its meeting July 31, or subsequently if the US economy weakens. (And there are some good arguments on the other side as well, if growth remains as strong as it has been over the last year.) But I find less persuasive one argument for easing: a perceived imperative to get inflation up to 2.0% or higher.
Federal Reserve Chairman Ben Bernanke set a 2% target for the US inflation rate in January 2012. Some other countries had already done the same. Japan followed suit a year later. Indeed Shinzo Abe’s successful accession to prime minister in late 2012 was predicated on the promise that monetary policy would raise inflation (Japan having previously suffered from negative inflation).
The case for trying to raise expected inflation
The logic was impeccable. With unemployment still high and growth still low in the aftermath of the 2008 Global Financial Crisis, some further stimulus was called for. But the nominal interest rate had already been pushed virtually to zero and could not be pushed much lower. Raising expected inflation could be a way to stimulate economic activity. An increase in the expected inflation rate would lower the real interest rate (which is defined as the nominal interest rate minus expected inflation). Making it cheaper to borrow in real terms would persuade households and firms to go out and buy more cars, buildings, and equipment. After all, the decision to build a house is more attractive if the value of the house and the rental rate are expected to rise.
But how were the monetary authorities to achieve the desired increase in expected inflation among the public? By announcing that their objective was to raise inflation to 2%, or higher; by being sincere in that announcement; and by keeping the foot on the monetary accelerator pedal (particularly via quantitative easing), so long as inflation had not yet reached 2%. The central banks did these things, increasing their monetary base many-fold. They did not lack sincerity. It is hard to see what more they could have done.
Did it work?
Did the plan work? It did, and it didn’t. It didn’t work, in the sense that neither in the US nor Japan, nor in the eurozone, has inflation yet attained 2 percent. The core US PCE deflator has been running at 1.7 % per annum lately. Japan’s inflation rate is stuck below 1.0%. Month after month, year after year, the authorities have had to explain that it was taking a bit longer to achieve the target than they anticipated. Standard measures of expected future inflation, such as from professional forecasters, remain below 2 % as well.
Meanwhile, however, the two economies returned to approximate full employment by 2016. US unemployment has lately fallen to 3.7 per cent (down from almost 10 per cent in 2009-10), its lowest level in 50 years. Japan’s unemployment is at 2.4%, down from over 5% in 2010. It is past time to declare victory.
Most monetary economists and central bankers, however, remain hung up on the need to deliver that 2% inflation target. They worry that their credibility is at stake. Some economists want to re-assert the target with renewed clarity. Some even want to raise the target from 2% to 4 per cent. One proposal that is popular among monetary economists is called price level targeting: the Fed would promise to achieve future inflation that is 1% above the 2% goal, for every year that it has already fallen short of that promised goal.
But why should these more ambitious commitments be credible or achievable after the simple 2 per cent target has been seen to fail?
Where to find an analogy? A sheriff draws his gun on a bank-robber, swearing that he will pull the trigger if the suspect does not surrender. He pulls the trigger, but the gun fails to fire. At the same time, the robber is run over by the deputy. Rather than declaring victory, the sheriff proclaims that the credibility of his threat is at stake and so, standing over the dead body, continues to pull the trigger and continues to draw blanks. Such strange behavior neither advances the cause of justice in the case at hand nor contributes to the sheriff’s long-term credibility.
Why did the expected inflation bullet not fire? Perhaps expected inflation — so central a part of economists’ models ever since 1968 — doesn’t really exist. To be more precise, the public’s expected inflation rate may not be a well-defined number in normal times of relative price stability. In a country like Argentina where the inflation rate is still high, households and firms find it worth their while to keep track of it. But most people pay little attention to the inflation rate, when it is running at levels as low as it has been.
Perhaps “expected inflation” doesn’t exist
A recent paper by Olivier Coibion, Yuriy Gorodnichenko, Saten Kumar, and Mathieu Pedemonte, “Inflation Expectations as a Policy Tool?”, marshals an impressive amount of evidence that undermines the notion that households and firms have well-informed expectations of future inflation, or that they even know what the inflation rate has been in the recent past.
Among the findings they present:
- “Large policy change announcements in the U.K., U.S. and eurozone, such as the declaration of the 2% inflation target, seem to have only limited effects on the beliefs of households and firms.”
- US “household expectations have averaged around 3.5% since the early 2000s.” This is well above the actual inflation rate, and also well above what professional forecasters and financial market participants were forecasting.
- “Hundreds of top executives were asked to report their point forecasts for CPI inflation over the next twelve months. 55% reported that they simply did not know. Of the remaining respondents, the average forecast was 3.7%,” which is again too high.
- Respondents were similarly far off internationally, according to studies in Germany, other euro countries and New Zealand.
- US households get little information when they read news coverage of FOMC meetings.
- The standard measures of expected inflation are designed in ways that can give misleadingly sensible answers. For example, some standard surveys of public inflation expectations effectively suppress wild answers by “priming” the respondents with a set of reasonable choices (“less than 1%”, “between 1% and 2%”, “between 2% and 3%”, and “above 3%”).
- To be sure, the authors interpret some evidence as showing “a causal and economically significant effect of inflation expectations on the economic choices of both households and firms.” But the direction of the estimated effect is ambiguous.
Why keep hitting your head against the wall?
If it is not worth the trouble for average people to formulate well-informed forecasts of inflation, that It is not a cause for concern. In fact, it reflects that effective price stability has been achieved. As was noted at a Brookings Conference last year,
“Fed Chairman Alan Greenspan once defined price stability as ‘that state in which expected changes in the general price level do not effectively alter business and household decisions.’ In other words, price stability is when inflation is low enough that people don’t think about changing prices in their daily economic lives.”
Why then should central bankers keep hitting their heads against the wall of the 2% target? To be sure, it is good for the monetary authorities to be transparent about what they expect inflation to be in the long term, as with the real growth rate and the unemployment rate. And for that purpose there is nothing wrong with 2%. However – and this is a radical suggestion — perhaps it is time for the Fed and other central banks, rather than doubling down on their oft-missed 2% inflation target, to quietly stop actively pursuing it in the medium term.
[A shorter version of this column was published July 25 at Project Syndicate. Comments can be posted there or at the Econbrowser post.]