Update on August 28, 2016
The current business cycle “is particularly dangerous,” said Ethan Harris, head of global economics research at Bank of America. Economies are late in the cycle, yet central banks “are all close to zero, and they are starting to lose the expectations war” with inflation, Harris said. Rather than consider radical changes, Harris said, maybe the best solution for the Fed at least is as simple as saying it intends to slightly overshoot its 2 percent inflation target temporarily to get prices up “as much as possible before the next shock hits.”
Source: Bloomberg, with emphasis added. Hopefully that sounds familiar to you. My only quibble is that they are unlikely to “say” it. They will just quietly do it while saying gently, oops, let’s not get too excited by that small miss.
As it turns out, my original posts pretty much all I have to say, even on reflection, so I will leave it up. I would add only two thoughts, one about the Yellen presentation itself and another about the idea of changing the inflation target. To me the second thought is the more interesting, but I am guessing the practically-oriented among you will disagree.
The first thought is that Yellen really hammered on one of my favorite themes, that forward guidance is a logical contradiction in a tightening program. She was not as blunt as I would be, I think understandably. But check out the lead chart in what amounts to just a three-chart presentation. She could not be clearer on the point that the rates guesses are now just perfunctory. They are there only because they were there.
My second point is not about Yellen but just a follow up on the idea of raising the inflation target. As mentioned earlier, I am agnostic on whether they should raise the target and adamant on the question of whether they will: not. But I want to link this back to the idea of helicopter money.
The monetization side of an h drop is just a promise to raise the inflation rate to obtain more seniorage — to finance the fiscal expansion. Mike Woodford has made the excellent point that in a world of perfect foresight a higher inflation target (in the presence of a deficit) and h money are equivalent. The point I would add is the coefficient required to map fiscal stimulus to inflation is the velocity of currency, which is far too high to allow this policy of h money to be plausible.
I am tedious on that point. But the cool thing about raising the inflation target is that it would at least be plausible. It assigns the right variable as the medium term objective. If you aim at, say, 4% inflation, then the Treasury can expect a bit more seniorage (among other things) from achieving that and might respond to the very small relaxation of the budget constraint by doing a bit of extra fiscal stimulus. The real work here is done by the higher inflation target and not by the “hydraulic” effects of a derisively small additional fiscal stimulus.
Conversely, if you start with the amount of fiscal stimulus to be monetized, you invite disaster, or more likely reneging, as I have explained. The cool thing about thinking about raising the inflation target is that it highlights this point, which is really devastating to h money. One might say that thinking about raising the inflation target is “heuristically useful” in that regard.
To hammer that home: consider this exercise. Reverse the sequencing of the thought experiment in the h money story. So, start with the amount of inflation you are willing to accept to get some “free” fiscal stimulus and then calculate how much free fiscal stimulus that buys you. With v pretty high, not much.
Higher inflation might erode the value of the federal debt. I do not deny that for a second. But that is not the mechanism the h money kooks are relying on. Plus it would really piss a lot of Americans off, understandably.
Well, how about hitting the one you have and then we’ll talk.
I want to write something about this that is substantial and non-snarky and has some shelf life. But ahead of Yellen, I figured I would put out a Readers’ Digest version. When I have something better, I will take this down.
My main point here is already in the market, so this is not particularly practically relevant, at least not immediately.
There is now renewed discussion about the Fed possibly raising its inflation target. San Francisco Fed President John Williams gave a talk on the idea, which riled up the liberals in the blogosphere and provoked some more serious study from economists over at Goldman. If you have access to their piece and if this subject interests you, then you might want to read it.
Greg Ip has been doing what strikes me as some good writing on this. He even admits to changing his mind on the subject. You don’t often see that. And it clearly impressed Brad Delong.
The Fed is not going to raise its inflation target because Republicans in Congress would shoot down the required changes to the Humprhey Hawkins Act, which establish price stability as central to the Fed’s mandate. Interpreting price stability as 2% measured inflation is a reasonable nuance. Four percent would not be. So I think this idea of raising the inflation target is a no hoper.
Whether it is a good idea is a separate discussion. I am old and old-fashioned enough to think that policy makers should try to keep their word and avoid major deceptions that result in large arbitrary transfers of wealth. On the other hand, the idea that you can’t raise the inflation rate from 2% to 4% without risking HYPERINFLATION! is dumb and a discredit to the other side. And maybe the zero lower bound would be less daunting if inflation expectations were above 3% rather than below 2%. I don’t know the technical side, and the normative side is not knowable, being – you know – normative.
Seeing this debate emerge reminds me that what is acceptable macroeconomic policy discussion in polite circles is pretty much a function of fashion. A couple years ago, I trotted out for colleagues’ consideration that the Fed would aim at above 2% inflation in the late cycle in order to have a credible plan to deliver on its 2% objective on average through the cycle. The only premise you need accept to get to this conclusion is that inflation falls somewhat incorrigibly in the wake of a business cycle peak.
But there was not much bid for the argument. People were willing to believe the Fed probably would err into above-2% inflation, but the idea they would target it seemed outré.
Now we are discussing raising the inflation target by a couple percentage points. I am sticking with my much more timid thesis. The Fed does not want to go into the next recession with core inflation not having broken 2%. So they will aim AT delivering above-2% inflation in the late cycle and not just tolerate the risk of it.
This idea will probably be slightly more convincing if Hillary takes the Presidency and the Dems get 50 seats in the Senate. It probably works in other scenarios too, just less reliably.