Does it have to be “close to, but below two percent”?

I have previously referred to the dangers of a new “impossible trinity” for the euro zone: avoiding its disintegration; avoiding a significant move towards fiscal integration; and avoiding any relaxation of the current definition of price stability.  In Wednesday’s post, I held out hope that stronger mutual insurance mechanisms could follow credible mutual assurances of disciplined policies.   Here I want to revisit the possibility of relaxing current definitions of price stability.   I realise this is taboo – but one I believe has to challenged given the nature and extent of the challenge facing the euro zone. 

The move to formal inflation targeting in the euro zone, Canada and the UK (as well as informal inflation targeting in the US) followed the traumas of the stagflation of the 1970s, not least the expensive efforts in terms of lost growth and employment to bring inflation down in the 1980s and 1990s.  However, while it is understandable that governments would not want to squander such expensively bought gains, the danger is that policymakers end up fighting the last war. 

The particular constellation of problems in the weaker euro zone economies means that it will be very difficult – maybe impossible – to pull through the crisis under current arrangements.   The boom-bust cycle in capital inflows have left a number of countries with current account deficits that cannot be financed.   There is no alternative to adjustment.   Given nominal rigidities, internal devaluation is a slow and costly process, requiring deep recessions to curb the demand for imports and induce the necessary wage/non-traded price cuts.   Slow growth further undermines the creditworthiness of States and banking systems, creating damaging negative feedback loops.   The euro zone may not survive the trauma under current policies.   A higher inflation target could lower the costs of adjustment. 

The danger is that the protection of hard-won low inflation becomes a mantra, preventing a broader reconsideration of the appropriate macroeconomic regime for the euro zone that properly reflects the full range of challenges being faced.  Good macroeconomic management could become a victim of its own past success in institutionalising a low inflation-targeting regime.   The question is whether it is possible to maintain much of the achievement of inflation targeting, while putting in place a macroeconomic regime that is consistent with a path through the crisis that avoids a disintegration of the euro zone. 

It is important not to lose sight of the strong case for inflation targeting.   The benefits are not limited to low and stable inflation.  (See, for example, this account from the Bank of Canada.)  By anchoring inflation expectations, a credible inflation targeting regime allows central banks the freedom not to have to respond to temporary supply-driven jumps in prices – due, say, to oil price or other commodity price shocks.   If inflation expectations are not well anchored, central banks may have to tighten policy because of they fear second-round inflation change effects, which would result from the temporary inflation shock becoming embedded in inflation expectations.   A credible inflation targeting regime can therefore have important benefits in terms of output and employment stability.   (The financial crisis has made it clear that central banks put too much faith in the sufficiency of inflation targeting, taking a too relaxed attitude to the build up of financial vulnerabilities due to excessive credit growth.   But this is not an argument against inflation targeting per se.   Rather it points to the need to use other instruments – including macro prudential tools – to ensure stability. )

The key question is whether the benefits of an inflation targeting regime could be obtained with a higher inflation target.   While there are risks to increasing an inflation target, the institutional structures of an independent central bank with an unambiguous mandate to achieve the inflation target over the medium run should allow the important benefits of an inflation-targeting regime to be protected.  

With the euro zone facing an existential threat, it is not enough to repeat mantras about the benefits of price stability.   Recognising the full range of objectives – including the value of a credible inflation targeting regime – it is time to reconsider the appropriate inflation-targeting regime for a euro zone in crisis.

30 thoughts on “Does it have to be “close to, but below two percent”?”

  1. With the euro “facing an existential threat” it is time to concentrate on its essential nature. It is one of a collapse of confidence, not disputes about economic criteria.

    Robert Zoellick puts it well.

    http://www.ft.com/intl/cms/s/0/c3200410-aa6b-11e1-899d-00144feabdc0.html#axzz1wTpMVWxx

    Notably;

    “Even massive injections of ECB liquidity may not be enough. When I ask developing-country veterans of financial panics what advice they would offer, their response is uniform: governments have to guarantee bank deposits and probably other liabilities. In the eurozone, the guarantees of some national sovereigns are unlikely to be sufficient and only that of the “euro-sovereign” will suffice. It is far from clear that eurozone leaders have steeled themselves for this step”.

    Draghi has reinforced the point by remarks before the EP which are remarkable coming from the EA’s Central Banker.

  2. @ John McHale,

    I am aware that in the past, Paul Krugman has struggled to get his mind around something similar to that which you describe above in your blog entry. Namely, that ‘victory’ as you describe, over inflation, that was so hard won in the 1980s and 1990s.

    From recollection, I think the direction that Krugman was going in, was an analysis something like: In the modern low inflationary economy, bubbles really do get out of control. But how much or how little Krugman has developed upon these kinds of ideas he was thinking about a few years back, is beyond the state of my knowledge. I’ll bet, that like everyone else, Krugman may have had to suspend some of his academic thinking and research for the time being, as he struggles to try and stay abreast of events as they happen daily.

    I am referring also, to the period around the height of the crisis, when he re-wrote some chapters of his textbook, and basically changed quite a lot of his thinking on how students should be taught in courses, in some key areas to do with banking etc. Regards, BOH.

  3. John McHale wrote,

    The boom-bust cycle in capital inflows have left a number of countries with current account deficits that cannot be financed.

    [break]

    A higher inflation target could lower the costs of adjustment.

    To develop on the point I was making above – I would indicate that in Krugman’s most recent (and as yet probably underdeveloped), thinking on matters to do generally with economics in the present day – I believe that Krugman would see quite a strong correlation between low inflation and the severity of the boom-bust cycle, that we have seen in modern day events.

    In fact, I do now recall, that in 2009, Krugman had urged quite pointedly, for the European economic policy makers to re-adjust upwards their inflationary targets.

    But there is a point about this, that is important. We simply do not know, how dangerous it is, to continue to pursue this current low inflationary policy direction, in Europe or north America – from a point of view, of future boom-bust cycles – which may prove to be even more damaging to western economies, than the 2008 and subsequent era has been. The best conclusion to reach at this point, might only be, to acknowledge it is an area that economists cannot fully understand at the moment – and at best, we have that analysis of the modern day trend – as provided by Krugman and perhaps some others. BOH.

  4. Ok. How plausible is a target much different to 2 – 3 %?

    Lets assume Austria, Germany, Finland, Netherlands are persuaded that EZ inflation should be targeted at 5%. How would you get it there?

    Would QE be vast purchases …of what? Surely not just EZ government bonds – all sorts of corporate bonds, US treasuries, UK gilts to get the FX rate down?

    –> Retaliation?

    Say you expand money supply, and you don’t reach the target. You do loads and loads more. You presumably get to a point where an eventual economic pick-up would properly leave exit strategies inadequate and you overshoot wildly to the upside.

    Just the fact that that is plausible will do really weird things to the yield curve – and id your crystal-meth powered QE overrides that so when people want out of long bonds en-mass but you are buying them all, aren’t you forcing inflation hedging commodities purchases?

  5. John McHale wrote,

    The key question is whether the benefits of an inflation targeting regime could be obtained with a higher inflation target.

    I would like to challenge this in a certain way. Apart from temporary inflation shocks becoming embedded in the system – if anything has started to become embedded in the system at this stage – it is a general expectation, that perhaps another bubble will just happen sooner or later, and so temporarily remove any current difficulties we find ourselves in. Certain, a criticism of policies such as the National Asset Management Agency (or any toxic asset resolution scheme from the S&L crisis onwards), could be that it practically depends upon the creation of a subsequent bubble to alleviate the wreckage from the last.

    The key question, is whether we can afford to stay on this permanent cycle of toxic asset resolution schemes, following by asset bubbles, which is the companion to a low inflationary environment in the present day.

    And while we are at it, lets be very honest about the reality of modern day monetary policy. It amounts to a lot more activity on the asset resolution side of things, and housing of assets of all kinds, and a lot less on the traditional money supply side. Monetary policy in 2012, is a vastly different beast from what it might have appeared to be in the 1980s and 1990s.

    In fact, if we were to be truly honest about it all, if one were to draw a proper diagram to represent the monetary policy of the European Central Bank, as of today, then it would have to include in its representation, all of those bad asset schemes of the European member states, wouldn’t it? What we have in reality in the European area, is a gigantic intervention by the European Central bank, something very like that of the Federal Reserve system in the United States. BOH.

  6. BOH stated above:

    What we have in reality in the European area, is a gigantic intervention by the European Central bank, something very like that of the Federal Reserve system in the United States.

    It is like in the present day affairs of Central banks, we have one hand proclaiming to be working to prevent commodity prices from escalating upwards – while its other hand, is doing its damndest to prevent asset prices from falling through the floor.

    One hand, doesn’t appear to know what the other is doing. Its like that old film clip of Peter Sellers, from years ago, of the hand that is trying to choke him. BOH.

  7. Off-topic, but is anyone working on Ireland’s strategy regarding IBRC and this from Blomberg:

    “Monti, Draghi and Bank of Italy Governor Ignazio Visco prodded Germany to back a proposal made yesterday by the Brussels-based commission, the EU’s executive branch, to allow the euro-area bailout fund to support banks directly instead of channelling the money via governments. The permanent fund, the European Stability Mechanism, is due to come on line in July.

    Helping Banks

    “People are actually working on finding ways that the ESM could be used to recapitalize banks,” Draghi said. “The issue is not so much the use of ESM money to recapitalize banks but whether this could be done directly without having to go to governments.”

    With creditor countries including Germany and Finland insisting they must be consulted before such funds are deployed, Draghi said there is a risk that “we have a big pot of money but nobody can touch it.”

  8. Paul Krugman writes at the end of Targets, Instruments, and the Zero Bound (Wonks Only).

    You can see where I’m going here. Menu B is, if you like, safer for the Fed than Menu A, because it is defined in terms of actions rather than results; the Fed can point to what it is doing, rather than announce a target for long-term rates or inflation that it might fail to hit.

    John,

    You will discover, that in this broadcast: Tonight with Vincent Browne, Vincent and panel review how the media are covering the Fiscal Treaty campaign. Broadcast:Monday, May 14, 2012 at 23:05, that the PR consultant for Declan Ganley’s NO campaign, Tom McGurk, makes a very similar point to that made by Paul Krugman, in relation to the US Federal Reserve.

    The Libertas PR consultant commented on how the Irish media usually only talks about the process, in times of a referendum debate – and not about the debate itself.

    In other words, the Irish public who derive a great deal of their understanding of the issues around a referendum from the source that is Irish media, are told about how the various sides of the campaign are doing, who is winning the most acceptance, what the likely turn out will be, what it will mean for the government, what it means for the opposition and so forth.

    That is every piece of information that the public receive through the media, is some information about the process of putting on the referendum, how it will work, what goes wrong etc. By the time that the referendum polling day, actually comes along, we haven’t really got to listen to much in depth discussion of the issues. All we have got is a blow by blow commentary about the process.

    This is what Krugman means also, about the US Federal reserve’s policies being determined according to ACTIONS, rather than RESULTS. That is, the Fed can tell its public constantly about its process, and what it is actively doing, at any given point in time. But it avoids the whole question, or where it intends to end up. BOH.

  9. @ All,

    Here is the relevant extract, by Mr. John McGurk from the Vincent Browne show, on May 14th 2012. BOH.

    The media rarely discusses what we are voting on. It is obsessed with process. Ninety percent of the coverage that I read in newspapers about the campaign, or listen to in the radio, is about who is up, who is down, what the strategies are, what the impacts are and who is targetting who. As opposed to what the thing is, that we are voting on. For that reason, I think that the media often times in elections transforms politics into a game show. Half the coverage is focussed on who has run the best campaign, as opposed to what the issues are.

  10. “With price stability under threat, it is not enough to repeat mantras about the benefits of the Eurozone.”

    I can’t cite any report of a Bundesbank official actually saying that, but it wouldn’t surprise me. At the end of the day it comes down to what Germans actually care about. Do they really want the Euro all that much?

  11. @ John
    Another very interesting and really balanced thread.
    I think that the ECB is actually right in tightly controlling inflation. There are a lot of upward pressures on inflation outside of ECB policy. These include wage pressures (they’ve already granted 4% pay increases) and energy prices which will rise again as they decommission their nuclear stations.
    The Euro has become a very weird animal. With individual currencies there were all sorts of revaluations and fluctuations based on foreign exchange markets. Now the same revaluations are occurring but in the form of wage cuts and tax rises which are happening with a similar frequency to the old Forex recalibrations. In effect austerity, internal devaluations and the likes are making the Euro a pan European currency in name only. It has become a different currency in each country.

  12. “I’ve been rereading Larry Ball’s impressive and disturbing what-happened-to-Ben-Bernanke analysis — an analysis that, I happen to know, has caused much consternation in some circles. (“Surely it can’t be just groupthink! There must be very good reasons the Fed hasn’t done more!”)

    Ball gets much more specific by pointing to an apparent shift in 2003, following an FOMC discussion of policy at the zero bound, in which BB appears to fully endorse the much more limited view of its policy options offered by Vincent Reinhart.

    As Ball parses it, before that meeting BB endorsed, at least as possibilities:

    – Targeting long-term interest rates
    – Currency depreciation
    – Money financed deficit spending
    – A Krugman-style inflation target

    After 2003, however, his menu seemed to have been reduced to:

    – Guidance on future short-term rates (the rates the Fed sets)
    – Purchases of long-term bonds and other nonconventional assets
    – “Oversupplying reserves”, that is, just pushing up the monetary base

    Maybe BB did indeed turn into a central banker and had to start trying to be a bit more specific than airing interesting ideas. Maybe his colleagues asked similar questions and more, to those I rattled off quickly above. If “dunno” was the consistent answer, you can see how he might have retreated when it came to actually taking responsibility for policy.

    This:

    “First, what does it take to target long-term interest rates? Since long rates are mainly determined by the expected path of short-term rates (but over a long horizon), it means making a more or less credible commitment to keep short rates low even when times look better. So it’s a credibility thing.”

    and committing to be irresponsible, runs straight up against my point about the yield curve above.

    This:

    “Currency depreciation is much the same thing: the value of a currency depends largely on investors’ comparisons of expected returns over a longish horizon (in fact, many forecasting models use long-term interest differentials to drive the exchange rate). So again, you can only keep your currency weak if you can credibly commit to low-interest policies far into the future; otherwise the markets will defy you (see what’s happening in Japan!)”

    just looks simplistic. “many forecasting models” almost all, are utter crap. Predicting FX rates anything like consistently is much more difficult than analysing economies – the swings can be wild, last years, and have continual investor psychology feedbacks in them. You can have mixtures of strong and weak trends in the presence of high and low short or long interest rates.

    I think German analysts would think that a government unable to sell bonds other than to its central bank, and doing so to finance its budget would be engaging in monetary financing – whether or not you can argue that a 10 year bond might for a credit-worthy state be sort of fungible with cash currently. This would not resonate with them:

    “In other words, you don’t know whether a deficit was really money-financed or not until the zero bound is no longer binding, and hence the effectiveness of allegedly money-financed spending depends on expectations — again.”

    If all Ben could do was wave his hands (if) when pressed then how would he have pushed his ideas through?

  13. It’d be useful to give some context to the debate around inflation targeting, and a modification of central bank targets. OF particular interest has been the mooting of an adjustment of targets by the IMF some years ago (led by Olivier Blanchard) and the ensuing debate.

  14. Anyway it’d be a mistake to believe central banks have an easy control button for inflation. The debate now is shifting e.g. *REHN SAYS GERMANY SHOULD HAVE ABOVE-AVERAGE WAGE INCREASES

  15. Increasing your money supply (inflation) is the equivalent of a liquor seller watering his stock. Is that so hard to grasp? Appears so.

    Spending more than your ‘take-home’ income means that some proportion of your spending is being done with a part of someone else’s income. Is that so hard to grasp? Appears so.

    Spending someone elses income is – borrowing; which has two consequences. One: you have to pay back (the fixed amount) that you borrowed. Two: there is a borrowing cost (which increases geometrically over time) which you also have to pay. And both of these payments have to come out of your FUTURE income (since you are overspending your current). Is this so hard to grasp? Appears so.

    There must be a valid cause for your current income to be less than your current expenditure – or the opposite. Set it in whatever direction you wish. So what is that cause (or causes) then? Well? Its NOT overspending. Its the reasons behind that overspending. So what are they then? Are they tractable? Appears not.

    “So, how does one increase one’s income then?”
    “Ah! I thought so, you ‘grow’.”
    “Ah! But what consititues growth then?”

    At this point the ‘battery low’ sign starts to blink!

    So, we have lots of exhortations about ‘competitiveness’, growth’, ‘creating jobs’ and other vacuous drivel being vomited up like bad pints (sorry Jeremy!). Maybe a semester with Cantillon, Smith and Ricardo might be enlightning. I actually have my doubts, but no harm in trying. Alternatively I recommend Samuelson’s 1948 undergrad economics textbook if you can get a hold of it.

    So, you need a surplus after you have paid your bills? Excellent. Well, you had better sell stuff you have made yourself, from your own resources, to strangers in foreign lands, for a non-fiat forex. Is this so hard to grasp? Appears so.

    There are a lot of dopey folk asserting that selling your own stuff to yourself (or worse, buying someone else’s grot) will create all the extra ‘growth’ and ‘jobs’ we need. Is this too difficult to refute? Appears so.

    What did the man say about attempting the same thing again and again, and expecting a different result?

    O’Brien has an ‘interesting’ opinion in the Business section of to-day’s IT. The man must have testicles fashioned from marine-grade stainless steel. But his observations have some relevance to my comments above.

  16. While inflation of course is not a worry now, I guess the central bank numbercrunchers would look at 2 issues of relevance to a recovery:

    1) it doesn’t take much extra demand these days for global commodity prices to rise;

    2) the ‘China price’ of the past 3 decades which saw the price of manufacturing goods plunge, is past.

  17. Ahh Brian your arguments are simplistic and old fashioned… dont you know you cant compare a states finances, even a euro zone states finances…. with those of a business or household…. deflicts and debt arent really that important for states….

  18. @Grumpy
    Re yours 9.35

    It’s only a few days since the ECB stated that direct financing of banks would contravene their statutes.

    Are things so bad that they are going to ignore their own statutes?

  19. It looks like the Yes side have it. The NYT say this may boost Angela Merkel’s strategy.

    Have the Irish voted for the demise of the euro?

  20. @Ceterisparibus

    the Irish have voted for something uncertain which does not yet exist. Their vote was an act of faith. Let’s see what it delivers.

  21. @Ceterisparibus

    It looks like the Yes side have it. The NYT say this may boost Angela Merkel’s strategy.

    A mixture of mendaciousness and cowardice got Ireland here, Fine Gael were mendacious, Labour cowardly and Fianna Fail a heady mixture of both.

    A Yes vote will undoubtedly help Angela and the neoliberal/technocratic right in Europe, both of whom plan a long and painful period of austerity, internal devaluation and market reforms for us and the Eurozone countries not bordering Germany generally.

    Now perhaps by submitting to Merkel’s will Ireland’s treatment will be less awful but as a shameful and degrading act of cynicism and desperation the Irish establishment support for the Fiscal Compact is exemplary.

  22. @ Garry: Yes, silly me!

    Now if’n I brought my Credit Card to the Central Bank would they give me ‘bonds’ to the value of my credit limit? What if I had several cards?

    As Baily said to Gogarty, “Will they *!%*”.

  23. @Ceterisparibus

    > Are things so bad that [the ECB] are going to ignore their own statutes?

    Are you serious? You know that the ECB has been violating its own statutes since at least when it decided to go on pretending that Greek debt was good collateral back in 2010.

  24. @grumpy

    I note that even stimulus megadove Richard Koo thinks it’s a bad idea to use monetary rather than fiscal policy as your primary or only form of stimulus. It might be interesting to rake through what he says about it.

    OTOH, I see that Willem Buiter thinks that the Eurosystem is good for almost €3.5tn of losses without having to break the 2% inflation target, and that this should be enough. (Though atm I’m not sure what he thinks it’s enough for – stimulating a recovery or just maintaining financial stability?)

    (Dunno nothing about economics.)

  25. re- Brian O Hanlon: ”Here is the relevant extract, by Mr. John McGurk from the Vincent Browne show, on May 14th 2012. BOH.
    The media rarely discusses what we are voting on. It is obsessed with process. Ninety percent of the coverage that I read in newspapers about the campaign, or listen to in the radio, is about who is up, who is down, what the strategies are, what the impacts are and who is targetting who..”

    – Another nasty development seems to be rating debates on ‘performance’ of participants rather than the contnets of arguments. It’s like a Hollywood Courtroom drama, twinned with Ursula Hannigan in the role of Simon Cowell for desert. Yeuch.

  26. “particulars, as every one knows, make for virtue and happiness; generalities are intellectually necessary evils. Not philosophers but fret-sawyers and stamp collectors compose the backbone of society” …Adilfus Huxley’s Brave new world

    The media loves particulars over generalities and it is always safer to concentrate on the details of process.

    Similarly a discussion on inflation targeting that fails to address the effect on interest rates is generally full of delicious detail. The generality ( to hold real interest rates in negative territory while deleveraging proceeds) does not seem to be addressed.

  27. “The danger is that the protection of hard-won low inflation becomes a mantra,”

    So what Krugman is suggesting is what? €100/liter gasoline? That is the solution? Needless to Krugman assumes elements of the economy that are insulated from inflation will not notice. The problem with his redistribution plan is unprotected elements of the US population are already rebelling against it, for example the removal of cost of living adjustments from state worker pensions in New Jersey, which some observers view as a prelude to a more general default by the (people of the) state of New Jersey.

Comments are closed.