Scott Sumner  

Central banks target inflation

Switzerland... The Power of Distributed Pract...

Andrew Sentance has a new post in the Financial Times, which is critical of the Fed's refusal to raise interest rates. The word 'inflation' does not appear in the article. Here's how it begins:

These are tough times for monetary policymakers. That is undeniable. In autumn 2008 and early 2009, the task was easy. Cut interest rates as fast as you can to as low a level as possible.
If this "task was as "easy" as Sentance suggests, then one wonders why the monetary policymakers did not in fact do this. The ECB policy rate didn't hit zero until 2013, and has since fallen even lower. So zero is not "as low a level as possible" and I don't think 5 years is "as fast as you can". Indeed even in the US rates weren't cut to zero at the September meeting after Lehman failed, or even in the late October meeting after the biggest banking crisis since 1933, plus a collapsing economy. Was December "as fast as you can"? I believe that I could have cut them faster. And are Fed rates "as low as possible"? If so, why did one Fed President recommend an even lower rate this week? Is he bad at math? And why is the lowest rate in Sweden and Switzerland and Germany lower than the lowest rate in the US, which is lower than the lowest rate in the UK?
Second, if interest rates cannot rise now, when will they increase? In the case of the US, growth has averaged over 2 per cent for more than six years since the recovery started in mid-2009. Unemployment has halved from around 10 per cent to 5 per cent over roughly the same period. Yet interest rates remain stuck -- close to zero. A similar position prevails in the UK.

A multitude of reasons have been advanced for delaying the first rate rise: sluggish growth in all the major western economies in 2011-12; the euro crisis in 2013-14; and now the Fed is citing weak economic growth in China and the impact this has on financial markets.

If you look around hard enough, there can always be a reason for not raising interest rates. But that highlights the key problem. Monetary policymakers are very timid at the moment. They are lions who have lost their roar.

When will rates increase? Perhaps when increasing rates will move the US closer to the Fed's 2% long run inflation target, not further away (as is the case today.) Yes "you can always find a reason for not raising interest rates." But when discussing those reasons, wouldn't you want to mention the Fed's actual inflation target? Isn't inflation targeting the core of modern central bank policy?

In fairness, the Fed has a dual mandate, and there is an argument for allowing inflation to run below target when employment is above target. There's even an argument that employment will soon be above target, and hence inflation should run a bit below target.

But even under that assumption (which I don't accept) it's hard to argue for a rate increase. The real problem is that the market doesn't just expect the Fed to fall short of 2% inflation for a few years, but rather for 30 years. Raising rates now would put you even further below the long run inflation target, leading to a loss of credibility.

The Fed shouldn't have set a 2% inflation target. But if they announce that they are targeting inflation at 2%, then they should act in such a way that we'll get roughly 2% inflation, at least over an extended period of time (not every single year.)

The discussion of UK and US monetary policy is taking place on the basis of a false premise -- that we can maintain near-zero official rates indefinitely -- and that this would somehow be a satisfactory basis for economic growth over the medium term. I do not believe that, and I do not meet many people in the business and financial world who do either. If they do have a view about long-term near-zero interest rates, it is that this is likely to drag the UK and/or the US into a low growth equilibrium like Japan. That would be a major policy failure for the leading western economies.
This is what might be called the "Neo-Fisherian fallacy", confusing cause and effect. Low rates in Japan are the effect of tight money (as Friedman pointed out in 1997.) Raising the fed funds target now won't make the economy grow faster, indeed just the opposite.
However -- in cricketing parlance -- the Fed is now on the back foot. Their decisions are getting behind the curve. A sharp interest rate correction between 2016 and 2018 is becoming increasingly likely. Central bank independence is not delivering the benefits we have been promised.
Actual, the markets are telling us that a future interest rate surge is getting less and less likely. Beware of former central bankers who think they know more than the markets. Regarding central bank independence, we were promised that it would deliver two things:

1. Low inflation.
2. Avoidance of stop/go policies timed to the election cycle.

It has delivered both. Which promise does Sentance think it has not delivered?

The real problem is not that central banks haven't done what their critics asked them to do, rather the real problem it is that central banks have done what their critics asked them to do. Today's critics of low interest rates are mostly on the right. These critics have argued for years that central banks should focus like a laser on a low inflation target, and basically ignore unemployment. Central banks did this and gave us the Great Recession. Now critics on the right complain that the central banks are not raising rates, and write columns pointing to the low unemployment, but not even mentioning the below target inflation.

Recall that Sentance said:

If you look around hard enough, there can always be a reason for not raising interest rates.
I'd say if you look hard enough you can always find a way to claim Fed policy is too expansionary. There were even people making that claim in 2008-09, when the need for stimulus was "easy" to see.

Comments and Sharing

COMMENTS (14 to date)
foosion writes:

Very nice post.

We don't know how low unemployment can go without triggering inflation. We do know that the Fed has an inflation target and inflation is not moving towards its target (quite the opposite). That should be enough reason not to raise raise. In a better world, the would be reason to lower them (QE or whatever).

Have you seen Krugman's latest? There's long been a question of who benefits from raising rates. It's far from clear. For example, those with the most wealth benefit from a strong economy and strong equity market. Krugman's answer is bankers would benefit (at least in the short term) and finance has a massive voice in policy debates. (BTW, the other answer is politicians whose party doesn't hold the presidency, as they seem to benefit from economic weakness).

A writes:

One pervese possibility is that the Fed may create the condition it fears: aggressive contractionary policy in response to accelerating inflation. If the market tests credibility by drifting over 2% PCE, then the Fed's response might be viewed as an attempt to disinflate significantly below 2%, in an ironic circle of causing economic volatility, and then justifying policy with such volatility.

Michael Byrnes writes:

Is it in any way conceivable that an (unstated) policy goal has become "keep interest rates low"?

If the Fed simply pegged the Fed Funds rate as low as possible (via truly easy money policy), this would fail, as rates (and especially long rates) would soon have to rise to avoid an inflationary catastrophe. What they have actually done will be far more successful at keeping long term interest rates down.

marcus nunes writes:

I once wrote that Andrew Sentance was the "Joseph Kono" of monetary policy!
But not one of them (exception to Kocherlakota) can see mon policy has been progressively tightening:

Rajat writes:

Great post. The desire to raise interest rates seems to stem from what Tyler Cowan calls 'mood affiliation'. Many economists and business people on the political right seem to think that low interest rates and QE are a lazy, left-wing way to improve the economy and that, like Andrew Mellon, the government needs to force pain on people (ie 'liquidiate everything') for the economy to genuinely improve. Little do they realise that the role of monetary policy is to allow their (and my) beloved Say's Law to work effectively!

Michael Byrnes writes:

This is interesting:

John Cochrane on Friday:

That is, of course, the exact opposite of what's happening now. Banks are lending the Fed about $3 trillion worth of reserves, reserves the banks could go out and lend elsewhere if the market were producing great opportunities. Spreads of other rates over the rates banks lend to or borrow from the Fed are very low, not very high. Deposits are flooding in to banks, not loans out of banks.

Paul Krugman today:

Remember, the Fed isn’t lending money at low interest to banks — banks, with their $2.5 trillion (!) of excess reserves, are lending vast sums at low interest to the Fed.
James writes:

The Fed may have an official dual mandate, but the lever pullers at the Fed could probably get away with devoting their entire attention to controlling any one variable whether it be NGDP, unemployment, inflation or the price of a specific metal like gold.

If the Fed just started targeting stable prices for alarm clocks, what is supposed to happen to enforce the inflation/employment mandate?

Julius Probst writes:

Hi Scott,
more things to worry about!
It seems like the neo-Fisherian fallacy has made it to the Swedish Riskbank (link to the paper below). I did not carefully go through their model, but the line of reasoning just totally seems backwards. It’s the entire “if we set a higher nominal interest rate, then inflation will adjust upwards” story again, confusing cause and effect, as you say. They totally ignore Wicksell, which is especially sad given that it comes from Sweden.

Anyways, here is a taste (p.17):

“According to the long run Fisher relation there is only one level of the policy rate that is consistent with a specific inflation target, given the long run real interest rate. If the policy rate deviates from this level during a longer period, there is a risk that agents in the economy may interpret this as a change in the inflation target. The agents may therefore have interpreted the long-lived cut in the policy rate as an intention to lower the inflation target from two to zero per cent in this scenario. In other words, if the central bank has an inflation target of two per cent and the long run real interest rate is two per cent, the policy rate must on average be four per cent if the inflation target is to be attained. If the policy rate instead averages two per cent, the inflation rate, as we have seen in Figure (6), will on average be two percentage points lower, i.e. zero per cent.”

Does anyone have any thoughts on it? Maybe somebody could forward it to Nick Rowe. He’ll probably go on a rant :D

Scott Sumner writes:

Foosion, Interesting comments. I plead ignorance on the question of bankers benefiting from higher rates. I don't deny it's true (Evan Soltas showed me some stock market reactions to the Fed decision that are suggestive.) But on the other hand I don't feel I understand the mechanism that well. Traditionally we think that what banks do is to basically borrow short and lend long. But when rates rise short term rates rise the most.

A, Fed overreaction to inflation is the most common cause of recessions. And the opposite problem is caused by underreaction to positive supply shocks.

Michael, I understand why you might think that, but I'd argue the opposite. The unstated goal is to raise rates, but the Fed is confused about how to get there.

Marcus, Thanks for the links.

Rajat, Even worse, they don't realize that their preferred tight money is what causes the low rates.

Michael, Interesting coincidence.

Julius, Thanks, I left a comment over at MoneyIllusion.

ThomasH writes:

Part of the problem is that the good that can come from "low inflation"/harm from "high inflation" has not been properly understood. Why should anyone care what inflation is, anyway? The answer is that prices are not constantly and instantaneously and costlessly renegotiated. People make plans for the future based on prices today and make long term contracts based on expectations of future prices. The higher inflation is and the longer it goes on, the greater is uncertainty about future prices. This Keynes-Friedman view implies that the good that a monetary authority can do by having "low inflation" is to reduce uncertainty about future price levels.

When the authority targets an inflation rate this translates into less uncertainty about future price levels only if it takes downward deviations from the rate target as seriously as upward deviations. (As Krugman joked, monetary authorities have to commit to being "irresponsible.") If it in effect has only an inflation rate ceiling and an inflation rate floor, the future price level is more uncertain. This to me implies that the target should not be the inflation rate in the first place but the future price level.

This kind of analysis is what Simon Wren-Lewis calls "mediamacro" writers like Sentance does not (want to?) understand. Or as Brad deLong says, "Why can't we have a better press corps?"

I also think the fact that monetary authorities do not seem to have a price level target that they are willing to stick to has implications for fiscal policy. It opens up the possibility that changing levels of fiscal deficits can have macroeconomic effects in ways that they would not have if monetary authorities had a firm target (because such a target would mean automatic offsets of changes in the fiscal deficit). But that is a separate discussion.

Lurker writes:

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Andrew_FL writes:

@Rajat-Mellon never said that. Hoover claimed he did to make himself look good.

B Cole writes:

Yes, the Fed has a dual mandate and no one seems to care that there is a hard numerical target for inflation but no hard numerical target for unemployment.

Given who is attracted to central banking policy boards, is this a good idea?


Jose Romeu Robazzi writes:

Isn't the amount of reserver the banks are holding at least partially a result of new regulatory rules adopted post Dodd-Frank and Basel III ? I would bet regulation is in part to blame for money velocity decreases in the last few years ...

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