One of the features of the economic environment is how monetary policy easing options are like weeds in a garden. As soon as you chop them down it feels like a new batch appears. This is particularly true of my subject of today which is that there has been a recent flurry of articles and suggestions that the inflation target should be raised usually to 4% per annum. This would replace the current level of 2% used by most of the world’s central banks. This is a situation which was aptly described by The Average White Band.
Let’s go ’round again
Maybe we’ll turn back the hands of time
Let’s go ’round again
One more time
Before we move onto the details of this I would like readers to stop and think exactly how an increase in inflation would help them? A faster rise in prices just on its own would make consumers and workers worse off. After all if inflation was an economic cure why did countries in the 1970s and 80s go to so much trouble to push it lower?
A paper has been published on the Voxeu website by Paul De Grauwe and Yuemei Ji and the essentials of the case made are shown below.
An inflation target too close to zero risks pushing the economy into a negative inflation territory when even mild shocks occur. During periods of deflation the nominal interest rate is likely to hit the lower zero bound (ZLB). When this happens, the real interest rate cannot decline further. In such a scenario, the central bank loses its capacity to stimulate the economy in a recession, thereby risking prolonging recessions that do occur.
Okay let me respond sentence by sentence. Firstly we have the implication that negative inflation is bad when we have seen that via a boost to real wages it can expand consumption in an economy. I first discussed this back in January 2015 with respect to the UK, Ireland and Spain. Also there is the issue that for many years high inflation and not low inflation was the problem so the proposed solution may well be dealing with a symptom rather than a cause.
The next sentence was presumably updated with the word “lower” as the authors would have been using 0% as the lower bound until a couple of years ago. With so many countries now having negative interest-rates ch-ch-changes have been required but the concept of a lower bound has seen so much revisionism as it has got well lower and lower. For example the current state of play in the UK allowed Mark Carney to in effect promise Bank Rate below the 0.5% which he previously called the “lower bound” for it. Mario Draghi has cut the ECB interest-rate to -0.4% below what he called the lower bound. Indeed the Riksbank of Sweden which has the lowest official rate if we look at the deposit rate of -1.25% told us this on Wednesday.
The Executive Board remains highly prepared to make monetary policy even more expansionary, if necessary, even between the ordinary monetary policy meetings. There is still scope to cut the repo rate further.
The repo rate is -0.5% and could be cut without lowering the deposit rate but it’s rhetoric is not one of a central bank which thinks that it is out of ammunition.
The final point of a central bank riding to the rescue in a recession has a problem. It is simply that if it was that simple we would not be where we are. Some 8 years or so into a credit crunch where central banks have fired their phasers repeatedly and run down the supplies of photon torpedoes we apparently still need more! More! More! As Agent Smith put it in the Matrix series of films and of course he lost.
The conclusion of the paper is as follows.
An inflation target in the range of 3% to 4% comes closer to producing a symmetric distribution of the output gap.
Ah the output gap that has been about as much use as a chocolate teapot in the credit crunch era. Also we are told this.
It turns out that an inflation target of 3% or 4% has more credibility than a target of 2%.
How? As central banks currently cannot mostly hit a 2% inflation target surely raising it would be even worse.
Japan as a test case
The Bank of Japan is the central bank which has most set its sights on the policy objective described above. It has just pushed the monetary base to above 400 Trillion Yen ( 403.9 to be precise) which compares to the 358.7 Trillion of January so as you can see it is expanding it very quickly. Yet for some this is still not enough.
With thanks to Mike Bird of the Wall Street Journal here are the thoughts of Credit Suisse.
The case for a 4 per cent inflation target for the BoJ
Okay so how would it be achieved?
We would argue that the central bank has actually been too disciplined (restrained) in its approach to monetization of government debt. ……… we think it possible for the bank to promise that monetization of government debt will be maintained over a more extended period of time.
I bet some of you thought I was joking with my “To Infinity! And Beyond!” critique provided by Buzz Lightyear. Trapped within this is the fact that we always are told we need more without any objective analysis of why what was previously regarded as “more” is not working. Let me pose some questions for that approach.
- This was supposed to provide a lower level for the Yen but in spite of an acceleration in the size of the monetary base the Yen has been appreciating. It is at 100.6 versus a US Dollar which itself has been strong.
- We were promised by so many places that wages were just about to turn a corner and places like Bloomberg and the Financial Times have told us it has turned a corner. Last night the Ministry of Labour reported that total wages fell by 0.2% in May compared to a year earlier.
Your typical Japanese worker and consumer will rather doubt the promises of those who tell them that higher inflation will be some sort of economic nirvana after the experience of 3 and a bit years of what was supposed to be that nirvana! In the theories and economic models wages will respond to the higher inflation whereas in the real world that would be against wage trends that have been in play for quite some time. Ivory Tower meets reality you might say. Or as Japan Macro Advisers put it.
After taking account of inflation, real wages rose by 0.2% year on year in May. However, when we consider that real wages in Japan has been declining for many years, the pitiful rise of 0.2% rise offers little consolation. In real terms, real wages are still close to the lowest point in 30 years.
Yep the improvement in real wages came as a result of lower and not higher inflation but our Ivory Tower experts would apparently at the stroke of a pen solve a 30 year problem. Does anyone believe that?
There is an elephant in this particular room and I note that it fails to get a mention in the Ivory Tower theories. It is of course the debt burden which will be inflated away more quickly with 4% inflation than 2% inflation. Debtors rule okay or something like that! Except that the price is very likely to be that workers and consumers will be worse off in real terms just after they have taken a hit anyway. After all when the UK had 5% inflation in the autumn of 2011 there was no compensating surge in wages and in fact real wages were hit hard.
Another issue is the claim that higher inflation targets allow prices to adjust relatively. It is not made in the cases above but no doubt it will be along. Let me help out with some UK data.
The CPI all goods index annual rate is -1.8%, down from -1.6% last month……The CPI all services index annual rate is 2.6%, up from 2.4% last month.
It seems able to have relative price changes with near zero inflation does it not?
The Bank of Canada looked into this and I note that on its way to suggesting a revisiting of the inflation target it told us this.
The main conclusion is that, in the absence of the zero lower bound, the optimal rate of inflation is zero or negative.
Well since their paper was published in October 2015 the zero lower bound is not what it was.