Reply to Arnold Kling
By Scott Sumner
Arnold Kling replied to me recent post discussing a 4% inflation target (a policy I oppose, by the way.) I strongly disagree with all 6 of his points. He is responding to this claim I made:
The simplest solution is to commit to buy T-bonds (and, if needed, Treasury-backed MBSs) until TIPS spreads show 4% expected inflation. At that high an inflation rate you don’t need much QE, because the public and banks don’t want to hold much base money.
1. Central banks have tried many times to commit to pegging exchange rates, which in principle seems easier to do than pegging an inflation rate. These attempts have often failed, as the central bank finds itself overwhelmed by private speculators. This suggests to me that one should be skeptical of the effectiveness of open-mouth operations.
I know of no examples where a central bank tried to prevent a currency from appreciating and had to give up the peg due to the actions of private speculators. (And no, the recent Swiss case was certainly not one of those examples. Denmark held on, and the Swiss could have also done so.) As far as I know the cases where currency pegs are overcome by speculators are those where a country is trying to prevent depreciation. Those cases have no implications for the claim that the Fed can raise inflation to 4%.
2. Suppose that the Fed backed up its commitment to 4 percent inflation with a lot of action. My belief is that it would take a great deal of action-an order of magnitude more than what we have seen.
In fact, no action would be needed, as the demand for base money at 4% TIPS spreads (i.e. 4% expected inflation) and zero interest on reserves, is almost certainly far lower than the current stock of base money. The Fed could raise the inflation target and do “negative action”, reducing the base. In all of human history I know of no example where there is 4% expected inflation and a substantial demand fore non-interest bearing base money. Arnold’s claim is sort of like, “assume a unicorn”. He’s postulating a 4% expected inflation rate and a high demand for base money. How is that even possible?
And even if it did take an order of magnitude more action—so what? I can’t think of any outcome better than foreigners financing America’s entire national debt at 0% interest at a time of 4% inflation. Sweet!!
3. By the time inflation reached its 4 percent target, there would be a great deal of “inflation consciousness” among investors and in the general public. We would get into a regime of high and variable inflation. You do not know whether inflation would tend toward 4 percent, 8 percent, or 12 percent.
The Fed implicitly targeted inflation at roughly 4% from 1982 to 1989, and these problems did not arise. By targeting the TIPS spreads we’d let the market direct monetary policy, not the Fed. I’d expect the outcome to be even better than during the Volcker years. If we’ve learned anything about monetary policy in recent decades, it’s that central banks using the Taylor Principle can easily keep inflation close to target, except at the zero bound. (And even then it hasn’t been all that far below 2%)
4. In this regime of high and variable inflation, prices would lose some of their informational value, as people find it harder to sort out relative price changes from general inflation. This would be detrimental to economic activity. Scott and I both remember the 1970s, and from a macroeconomic perspective, they were not pretty.
The 1970s were ugly precisely because we were not targeting inflation (or NGDP). A 4% inflation target would look nothing like the 1970s; it would be similar to the Volcker years (after 1982).
5. So fairly soon, you would see a reversal of policy, with Scott complaining about the stupidity of the Fed overshooting its inflation target. The Fed would take dramatic action to undo what it did before.
Again, inflation would stay close to 4%, so this problem would not occur.
6. After several painful years, we would be back to the regime of low and stable inflation.
A policy of 4% inflation is a relatively low inflation policy. So there’s nothing to go back to.
Again, I don’t support a 4% inflation target; it’s not a sensible policy. But it’s one of the easiest policies for any central bank to undertake, even easier than a 2% inflation target (as there is no zero bound problem.) It’s not optimal because NGDP targeting is better, but it is certainly feasible, indeed it’s hard to think of any macro aggregate targeting policy that is more feasible.
In much the same way, a gentle and persuasive central bank can convince base money holders to disgouge their hoards of cash through 4% expected inflation.