Monday, January 30, 2012

Inflation Targeting Formally Begins in the U.S.

The Federal Reserve just announced its first formal inflation target.  They set a target of 2% interest as a long term target for inflation.  This is in step with Bernanke's academic work on monetary policy and with the recent Fed moves towards transparency and their attempts to create expectations rather than simply respond to them.  Many central banks have already practiced this for some time.

Brief Case Study: Sweden

Sweden Consumer Price Index

Sweden has been targeting inflation since recovering from a currency crisis in 1993.  This gives us a long period of time to examine inflation targeting's effectiveness.  The first graph (above) shows the monthly inflation rate of Sweden since their online data begins in 1980.  Their maximum inflation rate during the period has been 5.2%, and the minimum -1.9% with the average being 1.56%.  The standard deviation has been 1.42%, but while it has had a lot of variation, it has been pretty centered around 1.5% as shown by the histogram below.

The histogram shows the number of times that Sweden has hit a given percentage of inflation since they introduced inflation targeting in 1993.  I added a box from 1% to 3%, with a line down the middle at 2% showing the target and the acceptable range.  This shows that Sweden has been conservative in their approach to their intention, which has been a static 2% inflation target ±1%.  It looks more like that they've targeted 0-3% inflation rather than 1-3%, which ended up with a median 1.5%.  This policy has been largely successful in creating relatively stable growth for their economy, as shown in the graph below which begins in 1993.

Target Too Low?

Almost immediately after releasing the target, it was criticized.  This is probably to be expected, but not in the way that I expected it to be.  One of the first critics of the policy was Paul Krugman, who argued that 2% is too low.  Two percent is a pretty standard number in inflation targeting central bank circles.  It would be more shocking if they chose to formally inflation target and didn't choose 2%.

Olivier Blanchard was an early major economist to write of raising the inflation target in his paper (along with Giovanni Dell'Ariccia and Paolo Mauro) "Rethinking Macroeconomic Policy" which considered more than monetary policy, but also fiscal and tax policies as well.  Blanchard mainly asks if there would be substantially higher costs and benefits to targeting 4% compared to 2% inflation.

Stephanie Schmitt-Grohe and Martin Uribe wrote an interesting paper in 2010 titled, "The Optimal Rate of Inflation" where they attempt to formalize some aspects of the debate on inflation targeting.  "For a realistic model of the monetary transmission mechanism must incorporate both major sources of monetary nonneutrality, price stickiness and a transactional demand for fiat money. Indeed, in such a model the optimal rate of inflation falls in between the one called for by the money demand friction—deflation at the real rate of interest—and the one called for by the sticky price friction—zero inflation. The intuition behind this result is straightforward. The benevolent government faces a tradeoff between minimizing price adjustment costs and minimizing the opportunity cost of holding money. Quantitative analysis of this tradeoff, however, suggests that under plausible model parameterizations, this tradeoff is resolved in favor of price stability."

They bring up an incredible amount of ideas that I hadn't considered.  They examine ways in which the Friedman rule, or the optimal monetary policy that focuses on zero opportunity cost to holding money,  could break down.  All three of these ways are related to taxation, whose relation to monetary policy I had not considered.

While I'm not sure if I agree with them, all of these are important concepts to consider, especially when current monetary policy is constrained by the Zero Lower Bound due to our current liquidity trap.  Formally announcing a target seems to be a way of creating expectations both for better and for worse.  The better is that it signals to the market that the central bank is taking steps to create inflation, and the market can often help by making the claim a self-fulfilling prophecy.  Similarly for worse, inflation hawks can be cooled by the setting of a reasonable level of inflation target.

The latter of the two is important as the Federal Reserve will eventually have to perform a tricky dismount of these current monetary policies.  They have undoubtedly increased the monetary base in shocking amounts.  Much of this has been done with relatively normal operations using Treasury security repo's, but much of it has been done with alternative monetary policies.  This has been done to combat liquidity trap conditions, but as those conditions ease, longer term inflation problems will start.  The Fed has a large amount of sub-prime mortgages and it is unclear whether, even now, that there is a market for those assets.  The point being that many of the assets that the Fed purchased might not be incredibly easy to sell.

John B. Taylor has talked about crisis policies of the Fed being unprecedented and that there is a need for a clear exit strategy.  This is due to the fact that if or when inflation does creep above the target, all of the old devilish aspects of relatively high inflation will creep back into society.  The chief of those being: increases in the cost of capital to the user.  I recently wrote an article in praise of Chairman Bernanke, and I stand by that post, but to be clear... the most tricky part for Bernanke's Fed is still to come.


Blanchard, Olivier and Giovanni Dell'Ariccia and Paolo Mauro.  "Rethinking Macroeconomic Policy."  Washington DC: IMF.  2010. 
     Working Paper.
Cohen, Darrel, Kevin Hassett, and R. Glenn Hubbard.  ED: Martin Feldstein.  The Costs and Benefits of Price Stability.  "Inflation
     and the User Cost of Capital: Does Inflation Still Matter?"  Chicago: University of Chicago Press.  NBER Conference Report. 
     1999.  Print.
Krugman, Paul.  "Two Percent is Not Enough."  The New York Times.  New York: New York Times Publishing.  1/26/12.  Web. 
McCallum, Bennett.  "Should Central Banks Raise Their Inflation Targets?  Some Relevant Issues."  Economic Quarterly. 
     Richmond: Federal Reserve Bank of Richmond.  Vol. 97, No. 2.  2011.  Journal.
Schmitt-Grohe, Stephanie and Martin Uribe.  "The Optimal Rate of Inflation."  2010.  Working Paper.
Taylor, John B.  ED: John B. Taylor.  The Road Ahead for the Fed.  "The Need for a Clear and Credible Exit Strategy."  Stanford:
     Hoover Institution Press.  2009.  Print.
Federal Open Market Committee.  "Press Release."  Washington DC: Federal Reserve System.  1/25/12.  Web. 

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