The problems facing inflation targets

Today I wish to discuss something which if it was a plant we would call a hardy perennial. No I do not mean Greece although of course there has been another “deal” which extends the austerity that was originally supposed to end in 2020 to 2060 in a clear example along the lines of To Infinity! And Beyond! Nor do I mean the Bank of Japan which has announced it will continue to chomp away on Japanese assets. What I mean is central bankers and members of the establishment who conclude that an inflation target of 2% per annum is not enough and it needs to be raised. The latest example has come from the chair of the US Federal Reserve Janet Yellen. From Reuters.

Years of tepid economic recovery have Fed Chair Janet Yellen and other central bankers considering what was once unthinkable: abandoning decades-long efforts to hold inflation down and allowing price expectations to creep up.

I am not sure if the author has not been keeping up with current events or has been drinking the Kool Aid because since early 2012 the US Federal Reserve has been trying to get inflation up to its 2% per annum target. It managed it for the grand sum of one month earlier this year before it started slip sliding away again. Indeed for a while the inflation target was raised to 2.5% which achieved precisely nothing which is why the change has mostly been forgotten. From December 2012.

inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal,

Of course the Bank of Japan has been trying to raise inflation pretty much since the lost decade(s) began. Anyway here is Reuters again on the current thinking of Janet Yellen.

In remarks on Wednesday, Yellen called an emerging debate over raising global inflation targets “one of the most important questions facing monetary policy,” as central bankers grapple with an economic rut in which low growth, low interest rates and weak price and wage increases reinforce each other.

There is a clear problem with that paragraph as this week’s UK data has reminded us “weak price” increases boosted both retail sales and consumption via the way they boosted real wages. The rationale as expressed below is that we are expected to be none too bright.

The aim would be a change of households’ and businesses’ psychology, convincing them that prices would rise fast enough in the future that they would be better off borrowing and spending more today……..Raising that target to 3 or even 4 percent as some economists have suggested would shift the outlook of firms in particular, allowing them to charge more for goods and pay more for labor without the fear that a central bank would step on the brakes.

They are relying on us being unable to spot that the extra money buys less. Oh and after the utter failure of central bank Forward Guidance particularly in the UK you have my permission to laugh at the Ivory Tower style idea that before they do things consumers and businesses stop to wonder what Mark Carney or Janet Yellen might think or do next!

The theme here is along the lines set out by this speech from John Williams of the San Francisco Fed last September.

The most direct attack on low r-star would be for central banks to pursue a somewhat higher inflation target. This would imply a higher average level of interest rates and thereby give monetary policy more room to maneuver. The logic of this approach argues that a 1 percentage point increase in the inflation target would offset the deleterious effects of an equal-sized decline in r-star.

In John’s Ivory Tower there is a natural rate of interest called r-star.

Meanwhile in the real world

Whilst I am a big fan of Earth Wind and Fire I caution against using their lyrics too literally for policy action.

Take a ride in the sky
On our ship, fantasize
All your dreams will come true right away

You see if we actually look at the real world there is an issue that in spite of all the monetary easing of the credit crunch era we have not seen the consumer inflation that central bankers were both planning and hoping for. The Federal Reserve raised its inflation target as described above in December 2012 because it was expecting “More,More, More” but it never arrived. For today I will ignore the fact that inflation did appear in asset markets such as house prices because so many consumer inflation measures follow the advice “look away now” to that issue.

If we move to the current situation and ignore the currency conflicted UK we see that there is a danger for central bankers but hope for the rest of us that inflationary pressure is fading. A sign of that has come from Eurostat this morning.

Euro area annual inflation was 1.4% in May 2017, down from 1.9% in April.

Tucked away in the detail was the fact that energy costs fell by 1.2% on the month reducing the annual rise to 4.5% from the much higher levels seen so far in 2017. As we look at a price for Brent Crude Oil of US $47 per barrel we see that if that should remain there then more of this can be expected as 2017 progresses. That is of course an “if” but OPEC does seem to have lost at least some of its pricing power.

Actually today’s data posed yet another problem for the assumptions of central bankers and the inhabitants of Ivory Towers. We have been seeing am improvement in the Euro area economy as 2016 moved in 2017 so we should be seeing higher wage increases according to economics 101. From Eurostat.

In the euro area, wages & salaries per hour worked grew by 1.4%…., in the first quarter of 2017 compared with the same quarter of the previous year. In the fourth quarter of 2016, the annual change was +1.6%

What if our intrepid theorists managed to push inflation higher and wages did not rise? A bit like the calamity the Bank of England ignored back in 2010/11. As an aside a particular sign that the world has seen a shift in its axis is the number from Spain which for those unaware is seeing a burst of economic growth. Yet annual wage growth is the roundest number of all at 0%.


Much has changed in the credit crunch era but it would appear that central bankers are at best tone-deaf to the noise. We have seen rises in inflation target as one was hidden in the UK switch to CPI from RPI ( ~0.5% per annum) and the US had a temporary one as discussed above and a more permanent one when it switched from the CPI to PCE measure back in 2000 ( ~ 0.3% per annum). I do not see advocates of higher inflation target claiming these were a success so we can only assume there are hoping we will not spot them.

The reality is quite simple the logical response to where we are now would be to reduce inflation targets rather than raise them. Another route which would have mostly similar effects would be to put house prices in the various consumer inflation measures.

Oh and something I thought I would keep for the end. have you spotted how the US Federal Reserve sets its own targets? I wonder how that would work in the era of the Donald?!

Music for traders

My twitter feed has been quite busy with suggestions of songs for traders. All suggestions welcome.


22 thoughts on “The problems facing inflation targets

  1. I have always said that nobody knows what the rate of inflation is in an age where Full Employment has been abandoned. Like so many things the needs of people have been ignored in the interests of building great corprorations. How can low wage jobs drive a consumption economy? How much higher can personal debt grow?

    There has been a disconnection somewhere along the line, our nation has become fractured.

  2. I am old enough to remember when an inflation target meant the number that you were trying to get DOWN to!
    I am not sure whether the powers that be are “tone-deaf”, as you say, or simply have no idea what to do. If they remember their economic text books from 30 years ago, they would have expected:
    1. Wages to be rising when unemployment is less than 5%
    2. The fall in the £ to turbocharge the economy
    3. Low interest rates to do the same
    4. Bond vigilantes to drive up bond yields when inflation rises as in the UK
    The dislocation of these factors (probably caused by global QE) does not leave the BoE with many recognisable tools.

  3. Great blog as always, Shaun.
    As Forbin noted yesterday, with low inflation it is hard for governments to pay down their debt, so the siren call for a higher target rate will always be attractive to some politicians. In fact, it was so attractive to the Justin Trudeau government in Canada that it did raise the target rate for the “true rate of inflation” from 1.5% to 1.7% with the October 2016 renewal of the inflation-control agreement, choosing to overlook an improvement in the measurement bias of the CPI since the 2011 renewal agreement of 0.2 percentage points. Another way of looking at this is that the 2% target rate of the 2011 renewal agreement is now a 2.2% target rate, since the same rate of inflation that would have generated 2.0% inflation under the 2011 agreement would now generate 2.2%. The danger in such a move is obvious. Next time in 2021, the Canadian CPI may have switched to annual basket updates, which would lower the measurement bias more, and this will again be ignored. Worse still, why would the next renewal agreement not include an increase in the formal target rate to 2½% or even 3%. The government could argue, reasonably enough, that a 0.2 percentage point increase in the effective target rate in the 2016 agreement was virtually ignored, as it was, so why would anyone be disturbed by a small increase in the formal target rate? Here is a link to my paper at this year’s annual CEA meeting in June. I am not happy with it, and will probably revise it a bit, without changing the basic content.

    • Hi Andrew and thank you

      Good luck with your paper. If Canada takes your advice it could be in the van of countries which reduce their inflation target below 2% per annum. After all 2% was plucked out of thin air rather than having any real logic behind it. One of the cornerstones of the argument was that you require a moderate rate of inflation for relative prices to change but out period of ~0% called that out as good price fell but services prices rose.

  4. Hi Shaun, you raise points about a measure which is these days very dificult to pin down. In this alternative world which Govts have created they want the conflicting measures to achieve contradicting outcomes, high inflation to ameliorate debt burdens but low interest rates to boost nominal asset prices.

    Real people are in a funk… rich people addicted to high asset values, poor people squeezed by the same high asset values but unable to access the low interest rates.

    Its a polarized nightmare and seems to be tending towards a mass voter revolution where the increasingly fewer wealthy people are desperately trying to maintain a status quo which is impossible to do.

    I suggest tonque in cheek that the Govt administered economy just needs to increase inflation by law. Now lets see, rule that all prices must rise 4% per annum ( lets say) .After all they’ve done this already for Train Tickets, Insurance, Air Travel why not do it for everything then we’d get that fabulous inflation. Simply raise VAT by 4% this year and another 4% next year.

    Everything else is controlled anway, the motorways switch themselves on and off, as do the mobile phone networks and the interweb information is going to be “groomed”. Why not control prices themselves?

    We can do this….

    Paul C.

    • I love the idea of jacking up VAT just so as to increase inflation. It could even be popular if accompanied by a large dose of helicopter money, courtesy of some more QE…

    • ” Everything else is controlled anyway ”

      so true , since 2000 or 2008 , depending on preferences.

      no more free market – have the traders noticed ? or just happy to coin it in whilst the sun still shines ?

      state sanctioned inflation – oh why not just print , print , print ?

      ‘B’ Arkers the lot of them …..

      here we are with NZRIP going to BIRP and with wages regressing , inflation rising .

      cant pay for house , cant pay off the student loan , cant save for a pension ( or forced into on with -3% returns ) , AI taking the best paid jobs than are not out sourced to India ( their might be some in IT that are good but the ones I have to deal with …. shocking really , just cheap , that’s all that matters – so the Boss can get a bigger boat )

      and the top 0.1% cant be nailed down to pay taxes ( remember the boast about paying less than the cleaner ? )

      theirs something rotten in the State of Denmark…..


      • The way to get people to pay taxes is to:
        1. Make it a criminal offence for an accountant or lawyer to set up schemes to reduce tax
        2. Imprison those breaking the law.
        At the moment, accountants and lawyers go on about it being their job to minimise tax liabilities, as though this is a simple case of advising people on legitimate tax breaks. The fact is that they have been setting up schemes, such as the film scams, where the “losses” are in fact loans straight back to the “investors”. This is not the same as you and I claiming our ISA allowance. It is flagrant abuse by the rich of their ability to employ expensive advisers.
        I don’t think that footballers or even Sir Philip Green would come up with their own wheezes.
        I write as an accountant who actually pays his tax in full.

    • price controls, wasn’t this recently tried in Venezuala ? Or the USSR experience, shortages, queues, black markets and low quality goods.

      I’m not touting no regulation, but the UK has the wrong sort of regulation, for example the horrendously high rail fares go to paying some overpaid managers. Unaccountable quango jobs on 6 figure salaries or unaccountable building managers on 6 figure salaries who can’t even sort basic safety.

        • Yes, it supports the theory of European wage convergence. Good for low wage new member states, but unpleasant for the longer standing members.

          It may be possible to link both Britain’s low wage rises and Greece’s wage declines to converging European economies. The British govt should be trying to ameliorate this by keeping housing costs, rail costs and water costs low.

    • reminds me of Jim Morrison of the doors in 5 – 1 “they’ve got the guns but, we’ve got the numbers”

  5. Hello again, Shaun.
    Regarding the US target inflation indicator, the US Fed has always operated with the personal consumption expenditure price index (PCEPI) in this role since it formally adopted an inflation target in January 2012. Over that time its annualized rate of inflation has been 1.2%. Ed Harrison has argued that the US Fed has treated 2% as an upper bound, not as a target. If you continue with that thought, the US Fed may have adopted, on a de facto basis, New Zealand Finance Minister Sir Roger Douglas’s April Fool’s Day, 1988 proposal for a 0% to 2% target range, which started the whole inflation targeting era. This would imply a target rate of 1%. Instead of seeing the US Fed as miserably failing to attain its declared 2% target, maybe it makes more sense to see it as slightly overshooting a de facto 1% target.
    As you note, the switch from the CPI-U to the PCEPI as the Fed’s preferred inflation measure (not yet an inflation target) in 2000, implied a reduction in the inflation rate. The US PCEPI has a chain Fisher formula that virtually eliminates upper level substitution bias. Upper level substitution bias was at least 0.5 percentage points in the Canadian CPI at the end of 1995, when the 2% target was first introduced in the world. The formal consistency in choosing a 2% target for the UK CPI and the euro area MUICP involved a logical inconsistency, since upper level substitution bias is less, and even more so for the US PCEPI, where it is non-existent. A target rate of 1.5% by the US Fed would have made more sense if they wanted to match the Bank of Canada’s target rate in terms of “the true rate of inflation” (the Bank of Canada’s term, not mine).

    • Hi James

      Firstly apologies. I have just reported this to WordPress and noted that there are other mentions of viruses and spam pop ups so it looks as though there may have been a general issue. I will make sure I run my own anti-virus as well.

      • I checked my computer after this notice but didnt find a virus. That doesn’t mean it isnt there though! Any details of what it is and if it has been cleared from your site?

  6. The solution is in fact the opposite of what the CB’s appear to be considering, which has been disproved comprehensively down the years (i.e. when inflation goes up demand goes down and people DON’T simply borrow to bring future consumption forward in the face of increasing inflation because “it’ll only cost more next year”).

    In fact the CB’s should take a big gulp and begin following the Fed’s lead, slowly increasing rates, then the savers will stop saving so hard and start spending more as their confidence in reasonable interest rates on their savings return and economic growth will follow .

    As for “how that would work in the era of the Donald” C’mon Shaun! Don’t be like the establishment! The era of the Donald is already here and so far the Fed’s independence is still working! Happy to hear comments like that if/when Trump interferes with the independence of the Fed (possibly when Yellen’s term comes to an end).

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