Tuesday, September 21, 2010

The Real Problem with a Higher Inflation Target

It's comical to read the reasons people give for why the Fed should not officially raise its inflation target. This one is really funny:
Part of the credibility problem stems from the political environment, especially in Congress. Imagine the day after the announcement of a plan for 3 percent inflation. Older people, creditors and workers on fixed incomes — all connected to powerful lobbies — would start to complain. Republicans would wonder whether they had found a new issue on which to campaign, namely, opposition to inflation. And Democrats would worry about what position to take. Presidents of some regional Fed banks would probably oppose the policy publicly.
Did you get that -- pensioners (who are more dependent on debt securities for income, and therefore more actively hurt by low interest rates) will get mad and those evil Republicans will then turn that into an election issue.

I have a more straightforward suggestion: the Real real problem with a higher inflation target is that the Fed has no tools to hit it. Monetary policy merely shuffles and changes the term structure of outstanding assets. It does not create new assets. Therefore, in an environment where aggregate demand is being held back by insufficient net financial assets in the private sector, the Fed can announce things until the cows come home, but it cannot influence AD, and therefore, inflation.

4 Comments:

Blogger Lord Keynes said...

So are saying that only large fiscal stimulus will raise inflation rates?

1:06 AM  
Blogger JKH said...

good point, w

I'd just add a couple of things:

- monetary policy is entirely about price: the short rate above the zero bound, and the yield curve at the zero bound; the tool is there at the zero bound, but its effectiveness is pretty uncertain and may only be marginal; one thing for sure we would agree on - the effectiveness at the zero bound has nothing to do with its implication for bank reserves per se or how banks respond to increased bank reserves

- the corollary goes back to your previous post as well; the economics profession is hopeless not only at understanding/specifying that a tool is required to hit an inflation target, but how that tool actually works at the zero bound, to the extent that it works at all

4:36 AM  
Blogger winterspeak said...

Lord Keynes:

In the current environment, yes, I am saying that only large fiscal stimulus will raise inflation rates.

More generally, the non-Govt sector has some endogenously determined desire to net save. This desire can only be funded by Govt deficits (via the fiscal channel). If the desire is underfunded, you get deflation. If it's overfunded, you get (demand pull) inflation. if it's funded just right, you get full employment with no inflation.

This desire also changes over time, so Govt needs to always fund it appropriately.

9:26 AM  
OpenID Ohm said...

Good Stuff...Reblogging:

"

In the current environment, yes, I am saying that only large fiscal stimulus will raise inflation rates.

More generally, the non-Govt sector has some endogenously determined desire to net save. This desire can only be funded by Govt deficits (via the fiscal channel). If the desire is underfunded, you get deflation. If it's overfunded, you get (demand pull) inflation. if it's funded just right, you get full employment with no inflation.

This desire also changes over time, so Govt needs to always fund it appropriately."

9:16 PM  

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