In monetary policy, 8k peaks are easier to climb than 7k peaks
By Scott Sumner
For several years I’ve been gradually pulling my hair out as I read one pundit/commenter after another claim that since the Fed is currently struggling to hit its 2% inflation target, there’s no point in setting a higher inflation target. That assertion is demonstrably false—and it’s not even debatable.
However, there are significant downside risks with these policy recommendations that I believe must be carefully considered before being adopted. First, the Federal Reserve is struggling to hit its current target of 2 percent and has come up short for four years. Market forecasts and expectations about our ability to hit 2 percent have fallen. If we announced a new higher target, it isn’t clear why anyone would believe that we could hit it. The Federal Reserve’s credibility could be weakened. To say it another way: Had Japan announced a higher inflation target a decade ago, would it have made much difference? I doubt it, because Japan too faces nonmonetary challenges.
Can we bring back Kocherlakota? I need to take a deep breath and regain my composure. Here are the facts:
1. For several years the Fed has been tightening monetary policy. This started with tapering, then with signals of an increase in interest rates, then an actual increase in interest on reserves. Now Fed officials are signaling that more rate increases are likely to occur. The Fed does this for one reason, and one reason only, to prevent overshooting of their target. If they were in fact “struggling” to hit their inflation target, it’s not clear how they would respond. But one thing that is 100% clear is that if they were truly “struggling”, THEY WOULD NOT BE RAISING THEIR FED FUNDS TARGET INTEREST RATE. This is a really basic point, which is taught in every single EC101 textbook. The Fed raises rates to prevent high inflation, not when it is struggling to achieve it. If you don’t believe me, look at the monetary policy chapter of any recent econ text. No central bank that is raising rates is also struggling to hit its inflation target. They may be failing to hit it (I agree with that claim) but they are not “struggling” to hit it. By analogy, a car driving north from LA on I-5 is not struggling to reach San Diego; they are failing to reach San Diego.
2. A higher inflation target would not be harder to hit than a lower target, it would be easier to hit, especially if it were a level target. The reason is simple. The higher the inflation target, the more room the Fed has to cut rates, and achieve their target through conventional means. In monetary policy, it’s easier to climb an 8000-meter mountain than 7000-meter peak. Your intuition from everyday life does not apply in the realm of monetary theory; it’s an Alice in Wonderland World, where nothing is at it seems.
3. The Japanese did in fact raise their inflation target in early 2013, and moved from mild deflation to mild inflation.
PS. Just to be clear, I do not favor a higher inflation target. My claim is that the “struggle to hit 2%” argument is completely wrong.
PPS. I seem to recall that K2 (pictured) is harder to climb than Everest. Is that right? K2 is certainly a more magnificent specimen, and more deserving of the honor “world’s tallest peak”, at least on aesthetic grounds.