How much extra room does raising the inflation target really give monetary policy-makers? The answer from new research by Jean-Paul L'Huillier and Raphael Schoenle is simple: it gives some room, but significantly less than intended. Gaining extra space for monetary policy is fundamentally difficult.
Interest rates have been low for quite some time, and the current Covid-19 crisis strongly suggests that this will remain a problem in future years. Chronically low interest rates create serious problems for the implementation of monetary policy, because low rates tie the hands of the central bank: If market rates are very low and close to zero, it is just impossible to lower them further to provide traditional stimulus. In this situation, the central bank is pushed into unchartered and more exotic territory when recessions hit, generating significant uncertainty.
The new study takes a deeper look at the scenario of what happens when one attempts to ‘escape’ from this situation by the obvious way: a slight raise in the inflation rate that the central bank targets over the long haul. Higher inflation is usually related to higher interest rates, and therefore, over time this should put the central bank back on a more comfortable footing, with a higher interest rate to start lowering rates from should it become necessary.
Moreover, inflation rates around the world have been so low that a little bit of extra inflation will surely not hurt anybody, instead, it might even carry the benefit of avoiding the damaging effects of entering a potential deflation.
But the key aspect of the new analysis is that the authors consider a crucial point: the central bank does not live in a vacuum, but instead it is bounded by how actors in a market economy perceive and react to their policy decisions. The main insight is that gaining more room for policy is not as easy as it may seem.
In fact, the study finds that agents’ incentives in a market economy make them behave as if they ‘pushed back’ against the strategy of the central bank. This pushback means that part of the intended extra room for policy is lost due to the change in behaviour of the private sector. Such potency loss of monetary policy is a severe limitation to the strategy itself, and is a point that should be considered carefully and quantified.
The authors’ own calculations suggest that the limitation in terms of getting extra room are substantial: between a half and a quarter of the extra intended room is lost. By way of example: If the target were to be raised from 2% to 4% (a possibility that has been extensively discussed by experts,) the central bank only gets between 1 or 1.5 percentage points of extra room.
This means that in order to get the full 2 percentage points that were intended, the target needs to be raised to 5% or more. This calculation shows the severity of the issue that monetary policy around the world potentially faces.
There are two ways of interpreting these results.
A conservative interpretation is that the identified channel provides a reason not to attempt raising the inflation target in order to achieve higher inflation, because the monetary authority needs to also fight against the loss of potency in order to gain extra room for monetary policy. This may not justify the extra costs of higher inflation.
Another interpretation, potentially of a more radical nature, is that – on the contrary – this channel provides a justification to raise the inflation target by more than intended or initially discussed (to say to 5% instead of 4%), in order to ensure getting enough room for monetary policy.
This last point relates the findings to the concept of the ‘timidity trap’ when escaping secular stagnations. Governments should not be timid when dealing with this type of issues. Which of the two interpretations above ought to be adopted seems to depend on the exact macroeconomic context, and on the relative importance assigned by society to restoring the traditional toolkit of central banks.
ENDS
Contact details:
Jean-Paul L’Huillier:
Brandeis University
Website: https://sites.google.com/site/jplhuill/
Twitter: @jplhuill
Blog posts: https://voxeu.org/article/raising-inflation-target-assessing-extra-room/
Raphael Schoenle:
Brandeis University and Federal Reserve Bank of Cleveland
Website: http://people.brandeis.edu/~schoenle/
https://www.clevelandfed.org/our-research/economists/raphael-schoenle.aspx
Blog posts: https://voxeu.org/article/raising-inflation-target-assessing-extra-room/