Floors and Ceilings in Inflation Targeting

So is this it? Last week I wrote about Bernanke’s press conference for TAPPED here, but the reality of it is sinking in now. The inflation target isn’t a target but a ceiling. Bernanke and the FOMC will make sure we don’t lose ground in the rate of the recovery but won’t make any effort to catch-up to where we should be. 7 million+ people’s productive lives will be left behind as the collateral damage of Greenspan and our economic elites cheerleading a leverage-induced asset bubble and their subsequent terror at the thought of historically low 3% inflation.

Ryan Avent:

here’s nominal GDP:

Core prices dip appreciably below their trend level in 2008, then even more so in 2010. And you can clearly see the huge departure from trend in the nominal GDP series.

At this point in recovery, the growth rates of both inflation and nominal GDP are approaching trend levels (though they’re not quite there yet). But a return to trendgrowth in output leaves the economy substantially, and perhaps permanently, below potential its potential level of output. That gap more or less corresponds to your employment problem.

The solution to the problem, of course, is a period of catch-up. But to return to the trend output level would require a period of above trend output growth, which would probably necessitate a period of above-normal inflation.

A few thoughts:

- I’m old enough to remember when a sustained period of higher inflation, above and beyond what the target is, was the preferred solution of conservative economists. Bloomberg: U.S. Needs More Inflation to Speed Recovery, Say Mankiw, Rogoff (May, 2009):

“I’m advocating 6 percent inflation for at least a couple of years,” says Rogoff, 56, who’s now a professor at Harvard University. “It would ameliorate the debt bomb and help us work through the deleveraging process.”…

Some investors are already worried that Bernanke will go too far. “We’re on the path of longer-term, higher inflation,” says Axel Merk, president of Merk Investments LLC in Palo Alto, California. “It’s good for debtors but it’s bad for creditors. It’s dangerous and irresponsible.”

- Inflation higher than the rate of 2009 is dangerous and irresponsible according to the investment community. Good to hear.

Speaking of the battle between debtors and creditors, how come nobody is mentioning that not hitting the inflation target is a transfer from debtors to creditors, or from all of us to the richest asset-holders at the top of the distribution? This is especially true for underwater homeowners.  Joe Gagnon brought up how underwater homeowners are locked into their mortgages and can’t refinance at the current rate and this made QEI less effective. It should also be noted that rate they are locked into contains expectation of a 2-3% inflation target. Those underwater homeowners are paying a premium for that rate and can’t refinance into the new lower rate. Damn it must feel good to be a rentier.

Should this change our notions of the morality of strategic default, that the money supply is purposefully being targeted in a way that disadvantages underwater homeowners relative to their debt holders?

- What is supposed to be done in terms of balancing the floor and ceiling of an inflation target band? I can’t find very much in the literature. The implicit assumption I’m finding is that we’ll never have a situation where opportunistically locking in disinflation isn’t a good idea. With one exception, I can’t find references to this problem in the The Inflation-Targeting Debate, a 2005 collection of essays edited by Michael Woodford and Ben Bernanke.

That exception is contained in Inflation Targeting in Transition Economies: Experience and Prospects by Jiri Jonas and Frederic S. Mishkin and it goes like this:

9.5.3 …How Much Should the Floor of an Inflation Target Be Emphasized Relative to the Ceiling?…

However, should an inflation-targeting central bank try to lock in a lower-than-targeted inflation once actual inflation falls below the targeted path if inflation is not yet at the long-run goal? Another way of asking this question is to ask whether a central bank should emphasize the floor of the inflation target as much as the ceiling and thus work as hard to avoid undershoots of the target as overshoots. As we have noted, the CNB significantly undershot its inflation target in 1998 and 1999, and less so in 2000. Similarly, at the end of 2001, inflation in Poland fell well below the NBP end-2001 target. What should central banks do in such situations?

Should they be upset at the undershoot and indicate that this was a serious mistake? Alternatively, would it be appropriate for them to lock in the unexpectedly rapid disinflation of previous two years and focus monetary policy on maintaining price stability from then on? A case could be made for acting opportunistically and using faster-than- expected disinflation to lock in this windfall benefit of lower inflation (Hal- dane 1999).

In practice, central banks have treated the floors of inflation-target ranges in different ways (Clifton 1999). Some treat them as seriously as upper sides of a band and have eased monetary policy to bring inflation back up inside the band (e.g., New Zealand in 1991), while others preferred to consolidate the unexpected rapid disinflation (Israel in 1998). The recent experience of Poland has shown the risks of trying to lock into inflation that is lower than originally targeted…

There are several problems with opportunistic disinflation and with treating the bottom of the band leniently. First, there is a possibility that opportunistic disinflation will not find much sympathy with politicians. Particularly if the disinflation that is faster than originally intended coincides with a significant weaken- ing of economic activity, there will be calls for a relaxation of monetary policy, even if this should mean a return to somewhat higher inflation….

Second, if rapid disinflation is a result of temporary external shocks like large declines in the price of commodities, it would be a mistake to assume that monetary policy could lock in such disinflation forever without large future costs. Once these shocks are over, prices of commodities usually do not stay low but rise again as global demand recovers….

Third, an opportunistic approach to disinflation could undermine the credibility of an inflation-targeting framework. By setting medium-term inflation targets, central banks attempt to establish a predictable environ- ment that would allow economic agents to plan for the future.

So the short answer seems to be that there is no agreed upon solution, and it’s up to the judgement of the person in the seat. Here’s to getting some better judgement in those seats.

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4 Responses to Floors and Ceilings in Inflation Targeting

  1. chris says:

    A case could be made for acting opportunistically and using faster-than- expected disinflation to lock in this windfall benefit of lower inflation

    Surely, if someone were going to make that case, they should start out by realizing that it’s only a benefit to some actors, and a harm to others? It’s not like disinflation is Pareto improving. There are losers, potentially lots of them.

    Damn it must feel good to be a rentier.

    Yeah, exactly. They’re the only ones the monetary authorities seem to actually care about. Rentiers must be protected though the skies fall, but if you slip up and accidentally transfer a bunch of everyone else’s equity to rentiers, that’s a “windfall benefit” that you should opportunistically lock in.

    With that kind of attitude, they’ll be slipping up more often than the Three Stooges On Ice.

  2. Mike Easterly says:

    I’m skeptical, Mike. Two rounds of QE seems to have gotten us a lot of asset price inflation without much employment benefit (although I recognize that unemployment might have been worse without it).

    More to the point, this sounds a lot like the discussion I remember going on circa 2003. I think we’ve done too much in this country to encourage debt, especially high-yielding debt, by offering a chance to refinance every decade or so. Put more succinctly, this is the Greenspan Put on an unprecedented scale.

  3. SPECTRE007 says:

    The CRIMEX can’t be trusted, and if anyone is just now figuring this out, I feel for your pain. The FED is boxed into a very scary corner at this point with too many dire feed-back loops to handle much like the guy spinning plates at a carnival. It’s all great until a black swan comes flying through the show upsetting the plates into a million different pieces.

    12% of GDP is deficit spending, 100% debt to GDP, total debt, both public and private, at better than 350% of GDP, a consumer with a debt to income ratio of at least 115% says they keep printing because it’s what is left. They will scare the sheeple with just enough disinflation to start the next round of printing. Initial Claims says it all.

  4. Pingback: The 2% Catastrophe: How One Number Explains the Miserable Economy |

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