I must be crazy

Because the rest of the world seems crazy. Even Cowen and Sumner seem to think changing the inflation target right now would be a good idea.

First, does the Fed have an inflation target and are expectations anchored, i.e. are they equal to the target? Yep and yep, see the graph Prof. Delong put up.

Second, what would the impact of a change in the target be? Suppose expectations remain anchored, increasing the target will increase expected inflation, shift the Phillips curve up and we would be right back where we started. More precisely, there would be no change in output and assuming the mechanism behind Okun’s law is invariant to this change in policy, there would be no change in unemployment. (No, I don’t think expectations of inflation are backwards looking, especially now. And even if they are backwards looking, this would increase the chance that changing the target would unanchor expectations. If I did something wrong, my parents were always more pissed if I lied to them about it.)

Third, why might increasing the target unanchor expectations? The Fed could be seen as acting with discretion; that they’ll up the target anytime the public or politicians start whining. Here’s a post explaining why discretion is bad. Its really hard for the Fed to get expectations reanchored.

Fourth, what would be the impact of unanchoring expectations? Inflation would increase and its volatility would be greater. If the public thinks the Fed will do whatever is expedient, they will expect higher inflation. Also, because the Fed’s behavior is less predictable, expectations and actual inflation will be more volatile. High inflation and highly volatile inflation are bad. My bet is that this *permanent* negative effect would be much greater in welfare terms than the cost of the *temporary* high unemployment we’re experiencing now.

8 thoughts on “I must be crazy”

  1. Higher expected inflation can also lower real interest rates if nominal interest rates rise less than inflation. This can increase investment and increase employment.

    If you like sticky nominal wages as a cause of high unemployment, then higher inflation will lower real wages and lead to higher employment.

    Also, if debt deflation is a problem, then higher inflation reduces the burden on debtors and lowers defaults. This can increase asset values on banks balance sheet and reduce other problems associated with debt deflation.

    I really don’t think raising the inflation target from 2 to 3% would “unanchor expectations”. By the way, this whole discussion ignores that the Fed does NOT actually explicitly inflation target, unlike the UK or Brazil which have explicit targets. Bernanke has traditionally supported an explicit target, but the Fed had not stated an explicit target as of now.

    Would any change in the inflation target unanchor expectations? Have we ever seen this in action (a change in inflation targeting unanchoring expectations)? Most hyperinflations are monetary, not expectational. Moving from an implicit target of 2% to a target of 3% is not really a radical shift.

  2. “increasing the target will increase expected inflation, shift the Phillips curve up and we would be right back where we started”

    This is not correct. It’s true that the Phillips curve says that higher expected inflation does not change the output gap but only increases current inflation, however, provided the nominal interest rate doesn’t rise the higher expected inflation feeds a lower real interest rate into the Euler equation and this results in an increase in aggregate demand.

    You can’t just look at the phillips curve, you have to look at all the equations simultaneously.

    http://canucksanonymous.blogspot.com/2009/06/phillips-curve-in-liquidity-trap_01.html

  3. Adam, “You can’t just look at the phillips curve, you have to look at all the equations simultaneously.” Hey that’s my line!

    The problem is we want to tell stories. One of my professors had a line, “in modern macro there are no stories, just solutions to systems of equations”.

  4. “The problem is we want to tell stories. One of my professors had a line, “in modern macro there are no stories, just solutions to systems of equations”.”

    I’m not sure if you’re agreeing with me or not. Let’s say you are, the next question is whether letting inflation expectations have some conditional variation is such a bad idea?

    First of all, I don’t think having a variable target (with the goal of stabilizing the output gap) is really the same as unanchored expectations like what happened in the 70’s. To me unanchored sounds like completely out of control.

    Next, it might raise the inflation risk preimium in long term interest rates but that’s no disaster. That risk premium would have been higher in the 80’s and 90’s and it didn’t kill growth. In the canonical NK model stabilizing inflation expectations is the same as stabliizing the output gap so you don’t feel your faced with a trade-off. But if it is one or the other aren’t we better to sabilize the output gap?

  5. Adam, what we know about crediblity is very crude. The Fed is credible or its not. If we knew more about how expectations are formed, then we could manage them in any way we want. But we don’t, so I think its dangerous to try messing with them. This is just my hunch, but I’m willing to have my mind changed.

    My simple model of expectation formation is that the Fed does simple and transparent things for a long time and the public starts to “get it”; a sort of learning by doing (or seeing). Any changes in what the Fed does would require the public to relearn the Fed’s policy and I don’t have a clue what those learning dynamics look like.

    Maybe a brave, fearless and credible Fed chairman could give one of those Braveheart speeches and convince everyone that the Fed’s new policy is credible. But I don’t think Bernanke is up to the task; in fact, nobody’s up to the task.

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