Topic 2: Should the inflation
target be raised?
Lecture to 3rd year undergrad ‘Current
Economic Problems’, Bristol, Spring
2015
Tony Yates
Overview and motivation
• Blanchard et al (2010)/Krugman (various):
– Inflation target needs to be higher to reduce
frequency and severity of visits to the zero lower
bound to interest rates.
• What is the zero bound?
• Case for monetary stabilisation policy and
how it’s normally conducted
Taylor Rule and the intellectual
background to interest rate
stabilisation
T
i t 
it1 c 

y 
y t y n 
t 
‘positive’: Taylor (1993) discovered that this rule fit past Fed policy well.
‘normative’: Work by many others showed that rules of this form do a good
job at stabilising inflation and the output gap
Woodford and others made the intellectual connection between stabilising
these things and welfare of the representative agent.
Rules ‘operationalised’ / improved by inserting forecasts/lags instead of
contemporaneous terms.
If there is a boom, raise rates, and vice-versa.
Inflation target and the room for
cutting
Great moderation
Two stylised central banks
responding to fluctuations in
the business cycle with policy
rates.
8
cb rates
6
4
2
0
-2
-4
0
5
10
15
20
time
Secular stagnation
25
30
8
cb rates
6
4
2
0
-2
-4
0
5
10
15
time
20
25
30
Lower inflation target means
lower average nominal interest
rates, which prevents rates
from tracing out the bottom of
the sine wave necessary to
smooth the troughs.
Issues
• Why does the average nominal interest rate depend on the
inflation target?
• How does the zero bound arise and is it really zero?
• Post-crisis lesson about the amplitude of the typical cycle
• Post-crisis lesson about equilibrium real rates
• Are there alternatives to interest rate stabilisation?
• What are the costs of incomplete stabilisation?
• What are the costs of inflation that offset benefits of such a
rise?
• Are there risks to credibility of raising the target?
• Is this cure or prevention?
THE FISHER RELATION
How raising the target helps through
the Fisher relation
T
i t 
it1 c 

y 
y t y n 
t 
If we calculate ‘steady state’, or ‘long run average when all
shocks cancel out’ of an economy following a Taylor Rule,
then we will find this:
T
i c 
r
This is the Fisher Relation.
Investors in the LR will demand compensation in the interest
rate to protect real value of their investment against inflation.
So ir rises one-for-one with the inflation target and real rates
THE ORIGINS OF THE ZERO BOUND TO
CENTRAL BANK NOMINAL INTEREST
RATES
Money demand and the zero bound
•Marginal liquidity services value of xtra
unit of real balances declines as liquidity
increases.
•To persuade people to hold larger real
balances, opportunity cost [the nominal
interest rate] has to fall.
•No different from Mars Bar demand,
where in price falls as you try to persuade
someone sated with Mars Bars to buy
another.
•Zero bound arises because cash, which
earns zero interest, dominates any –ve
interest rate investment
•At the zero bound, OMOs involve the swap
of one zero interest, default risk-free asset
for another
Zero bound
• From time to time rule dictates less than zero
interest rates.
• Yet: no-one can offer a negative interest rate
on an investment when an investor can earn
zero interest on cash instead.
• Central bank deposit rate<0: no one will
deposit.
• Central bank lending rate <0: a giveaway with
no impact on market rates.
But is the ZLB really zero?
• What is the asymptote of the marginal
liquidity services value of real balances?!
• More simply: at some point, have we got
enough, and does more become inconvenient
and actually costly?
• If ‘yes’, then rates can become negative.
• Hence not surprising we have seen some cbs
like Denmark, Switzerland able to cut rates to
<0.
Overcoming the ZLB
• Idea pushed by Gessel, Buiter, Kimball and
others.
– Flows from analysis of origins of the zero bound.
– tax cash. People will lend at negative rates, then.
– Abolish cash: tax electronic currency.
– Some argue that cash anachronistic and benefits
crime.
– Dismissed on grounds of radicalism.
SECULAR STAGNATION AND THE
EQ’M REAL INTEREST RATE
Secular stagnation
• Coined by Alvin Hansen in 1938 at AEA, talking
about pessemistic view of the supply side.
• Low rate of technical progress in the future.
• Demand side view argues that other forces
press down on equilibrium real rates, and
therefore average nominal rates.
Middle-aged people [like me] save for their old age. And increasingly so now as
state pension entitlements more uncertain than before. Pushes down on real
rates.
Cheaper capital goods means firms don’t need to borrow so much to finance
capital accumulation. So demand for savings falls, pushing downward
pressure on real rates.
Large flow of savings ‘uphill’ from growing emerging economies, mirrored by
borrowing of the already rich countries. Pushes down real rates.
Not just private saving in the Emerging markets either, public accumulation of
reserves too.
Crisis destroys safe assets
• Crisis destroys safe assets, eg:
• ABS markets close
• Corporate bonds lose their apparent safety
• Recovery/re-opening in many markets, but some
impairment persisted
19
Result: real rates decline
‘Secular stagnation’=lower eqm real
rate
T
i t 
it1 
c S

y 
y t y n 
t 
Many pressures pushing down on the equilibrium real rate, and therefore
on central bank interest rates.
T
i c S 
r S
To keep i-star at old level, and preserve old frequency of zlb episodes,
need to raise inflation target to offset the effect of lower real rates on
the constant anchoring i.
POST-CRISIS LESSON ABOUT THE
AMPLITUDE OF THE TYPICAL BUSINESS
CYCLE
Pre-crisis intellectual euphoria
• 60s-early 80s ‘The great inflation’.
• 80s-late 2000s ‘The great moderation’.
• Macro and financial policy problems
supposedly solved by inflation targeting,
independent central banks, and Nkeynesian
macro.
• Monetary policy potent due to careful
management of expectations.
• No more inflation scares or financial crises.
Post-crisis
• Large, financial-crisis-induced recessions
possible.
• Great moderation more due to good luck than
we thought.
• Need for large interest rate cuts much greater
than we thought.
• Estimates were of desired rate cuts of 5-10pp
at peak of crisis.
ALTERNATIVES TO INTEREST RATE
STABILISATION
Alternatives to interest rate policy
• Quantitative easing
– Central bank buys MT/LT maturity bonds
• Forward guidance
– Manipulate future rates, if current rates at ZLB
• Credit easing
– Buy private sector securities
• Conventional fiscal policy: automatic
stabilisers and discretionary fiscal policy
• QE: consensus from event studies that it
lowered yields on impact. But effect still
uncertain. May also be costs.
• FG: relies heavily on sophisticated forwardlooking behaviour and careful expectations
mgt by and credibility of cbs.
• CE: tried, but involves risks too.
• FP: political constraints eg US/UK.
COSTS OF INCOMPLETE
STABILISATION
Consequences of inadequate
monetary stabilisation
• (Risk of) Larger busts.
• (Risk of) deflation
– Nominal debt-deflation spiral
– ‘Postponing consumption trap’
– Menu costs…
• In extremis: Risk of trapping interest rates at
the zero bound permanently [eg Japan?]
entering a true ‘liquidity trap’
• RBC view is that business cycles are efficient.
• Monetary policy may not be the appropriate tool
for some fluctuations caused by real distortions.
• Lucas-calculation that micro evidence of riskaversion+rep agent model means costs of cycles
is very small.
• Heterogeneous agent models: for those who
bear costs of cycles (the poor), costs are very
large.
COSTS OF INFLATION
The tragedy and the bliss of the zero
bound
• At the zero bound, if it exists, we have
squeezed the marginal reduction in
transactions costs associated with holding
money to zero. This is good. This is the
Friedman Rule.
• But, we have also run out of room to use
interest rates to counter-act negative shocks
to the natural rate of interest.
Friedman Rule
T
i c  
r 
T
i 0  
r 
T
r  0  
0
At the Friedman Rule, with interest rates 0 in the long run, the inflation
target equals minus the real interest rate.
Prices fall at a rate equal to the real interest rate. ie Deflation!
Logic: set the inflation rate so that the real returns to holding money are
the same as those to holding a real asset.
That way there is no penalty to holding money, and the
transactional/liquidity benefits can be maximised.
Money demand and the zero bound
Zero bound maximises holdings of real
balances, and maximises social benefits of
holding them.
Up to this point, the marginal benefit of
holding real balances is still positive.
Since there is no social cost of producing
them, [money is practically free to create]
then why impose one via R?
Menu costs and relative price
uncertainty
• Prices change infrequently because it is costly
to change them continuously. Eg reprinting
menus.
• While they are fixed, other prices moving
because of inflation creates unwanted relative
price changes and misallocations of demand.
CURE OR PREVENTION?
Implementing an inflation target rise
T
i t 
it1 c 


By 
y t y n 
t 
Taylor rule dictates that in the short run, interest rates will
FALL if we raise the target [the RHS falls when target increases
by B (for ‘Blanchard’)].
T
i c 

Br
Even though in the long run, once new inflation target is
achieved This is the Fisher Relation.
Investors in the LR will demand compensation in the interest
rate to protect real value of their investment against inflation.
So ir rises one-for-one with the inflation target.
Implementing Blanchard’s inflation
target increase
• Since interest rates have to fall, other things
equal….
• Raising the inflation target won’t increase
inflation if rates are stuck at the zero bound
• Unless you believe in efficacy of alternative
policies, or inflation expectations increase ‘by
magic’.
• Assertion: preventative policy for the future,
otherwise risk setting central bank up to fail.
CREDIBILITY ISSUES WITH RAISING
THE TARGET
Credibility problems with raising the
target
• Comes after a long period of inflation > target, + may look
like ex-post locking in.
• Raise suspicion that every time there is a problem, inflation
target will be raised.
• Whole point of target was to eradicate the suspicion that
inflation target would be used for electoral/political/realdebt-reduction means.
• Already had index changes that moved the goal-posts.
• UK regime is delicate and discretionary as it is. [Target can
be changed every year]
• Some other cbs set their own target, so setting their own
moving target problematic.
• Imprecise ‘slippery slope’ arguments.
But!
• Credibility cuts both ways.
• Cost of episodically failing to meet your target
because of the ZLB creates reputation for
incompetence.
• Over time, legitimacy of monetary framework
may erode if it is not seen to learn lessons of
crisis.
• Losing legitimacy is first step to losing control,
and all the good aspects (like instrument
independence) of the monetary framework.
Recap
• Lower eqm real rates, greater amplitude of
cycles: we will hit ZLB more than we thought.
• So raise target.
• Not now, as no instrument. It’s prevention,
not a cure.
• Costs of a little more inflation moderate.
• Alternative instruments tried, but still
uncertain, or unwieldy, and haven’t averted 6
year stay at the ZLB.
Recap ctd
• Risks to credibility, but they cut both ways.
Leaving the framework as it is may be risky
too.