Ivory Tower Types Fall for Bigger Inflation Fix
Folks who have a vivid recollection of the Great Inflation of the 1970s must wonder why anyone would wish even a trace of that upon future generations. Yet that seems to be the risk some economists are willing to take.
The idea that the Federal Reserve could “fix” things faster with a bit more inflation keeps popping up in academic circles, which is probably where it should remain.
Pretty soon, Harvard colleague Greg Mankiw was advocating higher inflation as a cure for slow growth -- and a preferable option to additional fiscal stimulus. In 2010, Olivier Blanchard, chief economist at the International Monetary Fund, put his imprimatur on the idea. In a paper examining the lessons from the financial crisis, Blanchard and his co-authors suggested that the benefits of a 4 percent inflation target, to minimize the risk of deflation in response to shocks, might outweigh the costs.
Let’s leave aside for the moment the punishing effect higher inflation has on savers, whose investments are paid back in devalued dollars. I needed to understand the mechanics of what seems like a wacky, and unworkable, idea. So I posed some questions to Rogoff.
He said in an e-mail that if the Federal Reserve -- or any central bank -- were to raise its inflation target, that would lift inflation expectations and reduce short- and intermediate-term real rates. (The real rate is the nominal rate minus expected inflation, which nowadays can be inferred from the spread between nominal and inflation-indexed bonds.) In theory, this wouldn’t affect real long-term rates, Rogoff said. In practice, I’m not so sure.
Rogoff doesn’t like Blanchard’s idea of adopting a permanent 4 percent inflation target. He said a “short burst of moderate inflation” -- two years of 6 percent inflation -- would speed the deleveraging process.
The operative words in that policy recommendation are “short burst” and “moderate inflation.” For all its concerted effort -- almost five years of zero-percent interest rates, large-scale asset purchases and forward guidance -- the Fed can’t even hit its 2 percent target from below. I’m not saying the current 1.3 percent inflation rate is an alarming development that needs to be addressed. I’m just wondering how an institution is going be successful targeting something -- inflation -- that is determined by today’s monetary policy with “long and variable lags” (see Milton Friedman). A “short burst” could be prolonged. “Moderate inflation” might be anything but. And inflation expectations might take on a life of their own.
If a 6 percent inflation target would accelerate the deleveraging process, why stop there? Why not 8 percent? Or 10 percent? Wouldn’t that speed the process?
You get the point.
Then there’s the small matter of central bank credibility. Everything we hear and read about central banking today emphasizes the importance of communicating objectives clearly in order to influence the public’s expectations and behavior. Why would central bankers, who have fought hard to earn credibility with financial markets, forgo that trust for short-term gains? And why would we believe anything they ever told us again?
“It’s a slippery slope,” said Marvin Goodfriend, professor of economics at Carnegie Mellon University and a former research director at the Federal Reserve Bank of Richmond. It introduces the idea that if the central bank were willing “to do something for short-term purposes today, it would do it again for short-run purposes.”
Mankiw, also via e-mail, offered a different argument to support the idea.
“Think of it as the Fed announcing it will keep future short rates lower, for any given inflation rate, than it otherwise would have,” he said.
The long-term rate is the sum of the current and future expected short-term rates. That’s an arithmetic calculation. A potential buyer of a 10-year Treasury note, for example, will earn a certain return from rolling over a short-term rate for 10 years. In order to induce him to lock in for a 10-year period, he would need to earn the expected short-term rate for 10 years plus a term premium, or compensation for accepting the interest-rate risk during that period.
In theory, Mankiw is right. Ceteris paribus -- Latin for “with other things equal” and the fallback for all things economic -- the longer the Fed is expected to hold the overnight rate at zero, the lower the implied long-term rate.
But other things aren’t equal; they never are. In an econometric model, maybe, the central bank can target higher inflation for two years without affecting nominal long-term rates. In the real world, bond investors are going to look at 6 percent inflation and project 8 percent or 10 percent. Nominal bond yields will rise to incorporate higher inflation expectations. Real yields might not rise, but it’s unlikely they would fall. And long-term rates are what matter for capital investment, which is key to increasing the economy’s growth potential and raising productivity.
Bad ideas never die. Just this week in a blog post, economist Noah Smith advocated higher inflation -- 4 percent or 5 percent -- for the next decade. The only downside to higher inflation, he wrote, is the “nuisance cost” of changing prices.
Not to worry. The idea of raising the inflation target “has no traction among central bankers,” Goodfriend said.
That won’t stop academics, who are enthralled with an idea that looks good on paper. However, it’s a comforting thought to those of us who live outside the ivory tower.
(Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist.)
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