The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.

Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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February 16, 2010

Do we need to rethink macroeconomic policy?

The aftermath of a crisis is always fertile ground for big thoughts. Big thinking is exactly what we get from Olivier Blanchard (the International Monetary Fund's director of research) and his colleagues Giovanni Dell'Aricca and Paolo Mauro, in their new overview of the financial crisis and what it means for how we think about and, more importantly, practice macroeconomic policy. Titled, appropriately enough, "Rethinking Macroeconomic Policy," one of the more provocative parts of their analysis was highlighted in the Wall Street Journal:

"Central banks may want to target 4% inflation, rather than the 2% target that most central banks now try to achieve, the IMF paper says.

"At a 4% inflation rate, Mr. Blanchard says, short-term interest rates in placid economies likely would be around 6% to 7%, giving central bankers far more room to cut rates before they get near zero, after which it is nearly impossible to cut short-term rates further."

Paul Krugman approves, as does Ken Houghton at Angry Bear, who concludes with this comment:

"None of the major Macro work ever done, from Barro forward, has ever found damage to economic growth from 4% inflation."

I suppose that the modifier "major" provides something of an escape clause, but as a general proposition there is at least some evidence that 2% is preferable to 4%. From the IMF itself, for example, there is this

"The threshold level of inflation above which inflation significantly slows growth is estimated at 1–3 percent for industrial countries and 11–12 percent for developing countries. The negative and significant relationship between inflation and growth, for inflation rates above the threshold level, is quite robust..."

… which confirms the results of an earlier IMF study:

"Our more detailed results may be summarized briefly. First, there are two important nonlinearities in the inflation-growth relationship. At very low inflation rates (around 2–3 percent a year, or lower), inflation and growth are positively correlated. Otherwise, inflation and growth are negatively correlated…"

To be sure, there are plenty of studies suggesting modest increases in the rate of inflation from the levels currently targeted by many central banks would not be problematic—here, for example. But the point is that the evidence is not clear cut that an increase from an average rate of inflation in the neighborhood of 2 percent to the neighborhood of 4 percent would be innocuous. And there is always this element, noted by John Taylor in the aforementioned Wall Street Journal article:

"John Taylor, a Stanford University monetary-policy specialist who served in the Bush administration Treasury department, says that inflation could become hard to constrain if the target is raised. 'If you say it's 4%, why not 5% or 6%?' Mr. Taylor said. 'There's something that people understand about zero inflation.' "

So, the issue comes down to whether the uncertain costs of raising the average inflation rate is justified by the goal of avoiding the zero bound. At Free Exchange, the blog of The Economist, there is some skepticism:

"… the value of avoiding the zero bound depends on the seriousness of the macroeconomic situation. From the vantage point of 2010, a higher target rate seems like a great idea, but economic crises this severe are rare events. Even if there are only small costs to a 3% target relative to a 2% target, they may not be worth the trouble if the goal is to avoid serious trouble once every 80 years.

"There is a concern that with a higher level of inflation, inflation will become more volatile and expectations less anchored. At the same time, the higher target might not be enough to handle a recession as deep as the most recent downturn; to achieve the equivalent of a Taylor rule indicated -5% federal funds target without being constrained by the zero lower bound, the Fed would need to target inflation at at least 7%. Separately, these criticisms seem compelling, but taken together they cancel each other out."

Those are good arguments in my view, but my doubts about running policy to avoid the zero bound run even deeper. Among the lessons taken from the financial crisis, I include this: The "zero bound problem" was not all that big of a problem at all.

The Federal Open Market Committee moved the federal funds rate target to its effective lower bound (0 to ¼ percent) on Dec. 16, 2008. After a very rough start to 2009, gross domestic product (GDP) growth improved substantially in the second quarter. By the third quarter, growth was positive and, as far as we currently know, clocked in near 6 percent in the fourth. Is this the stuff of zero bound disaster?

In fact, Blanchard and company acknowledge that…

"It appears today that the world will likely avoid major deflation and thus avoid the deadly interaction of larger and larger deflation, higher and higher real interest rates, and a larger and larger output gap."

… but follow up with this:

"But it is clear that the zero nominal interest rate bound has proven costly."

Clear? Proven? I don't see it, and the IMF authors, in my view, explain why the zero bound problem was of limited relevance in the recent crisis:

"Markets are segmented, with specialized investors operating in specific markets. Most of the time, they are well linked through arbitrage. However, when, for some reason, some of the investors withdraw from that market (be it because of losses in some of their other activities, loss of access to some of their funds, or internal agency issues), the effect on prices can be very large. In this sense, wholesale funding is not fundamentally different from demand deposits, and the demand for liquidity extends far beyond banks. When this happens, rates are no longer linked through arbitrage, and the policy rate is no longer a sufficient instrument for policy." (I added the emphasis.)

The highlighted passage, of course, does not say "the policy rate is no longer a necessary instrument," and I certainly cannot prove that the trajectory of the economy in 2009 wouldn't have been better if only we had another 100 to 200 basis points in the tool kit. But color me a skeptic, and put me down on the petition to not experiment with higher inflation to avoid a problem that was not so clearly a problem.

Update: Related thoughts, from Mark Thoma and from Caroline Baum.

By Dave Altig, senior vice president and research director at the Atlanta Fed

February 16, 2010 in Inflation , Interest Rates , Monetary Policy | Permalink


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The severity of the zero bound problem depends not only on the depth of a downturn, but also on the level of equilibrium (full-employment) real interest rates.

Keynes in his General Theory discusses how growing prosperity leads to a higher saving rate (a saving glut?) and lower equilibrium interest rates, which limits the effectiveness of monetary policy. This is one of the reasons why he advocates a strong fiscal policy. So if we indeed experience a global saving glut then we can either follow Keynes’s original advice and rely on fiscal policy (maybe for a very long time) or we can increase the target inflation rate. This is something Keynes did not think about because his model did not include inflation expectations, but it would be a natural extension of his ideas.

From this perspective, the key questions are whether the saving glut is real, whether it is likely to persist and how much it affects equilibrium interest rates. If we indeed experience a permanent decline in equilibrium real interest rates that would in my view constitute an important argument in favor of a higher inflation target.

Is there enough evidence to support the ‘saving glut’ argument for a higher inflation target?

1) First of all, the Flow of Funds Accounts show that in the 00s full employment became possible only when net borrowing (adjusted for net issuance of equity) reached 15% of GDP, compared to 8% of GDP in the 1990s.
2) This increase in the full-employment level of net borrowing strongly correlates with the US current account deficit, suggesting that it reflects various trends in the real sector, rather than simply an increase in the level of leveraged financial investment.
3) It seems likely that the high level of borrowing observed in the 00s could be sustained not only because the interest rates remained low, but also because the real estate prices were going up (the collateral effect). Without the collateral effect, full employment would most likely demand much lower interest rates than what we saw in the 00s. It is possible that the real fed funds rate may remain negative even at full employment. If this is indeed the case then a 2% inflation target would put a very serious constraint on monetary policy.

So, at first sight there is at least some evidence in favor of a higher inflation target. This evidence is far from being conclusive, since the relationships between various macroeconomic variables are very complicated, but I think this particular argument in favor of a higher inflation target deserves much more attention than it now receives.

Posted by: Doctor Who | February 16, 2010 at 06:30 PM

Blanchard's reason for suggesting a higher rate of inflation is to give central banks more room to cut rates in an emergency -- to get farther from the zero bound. Why not consider negative rates instead? There is no reason depositors cannot be charged for leaving funds on deposit, which is effectively a negative rate. The Fed has the authority to charge depositors for holding excess reserves. This avoids many of the distortions introduced by higher inflation.

Posted by: Douglas Lee | February 17, 2010 at 09:13 AM

If I may say so, I think that you (not that you are the only one) are missing the point here, and treating Blanchard et al with too much respect. Whatever it actually says, I do not think that this proposal is about targeting 4% as opposed to 2% inflation in the abstract. It is probably true that the efficiency cost of 4% underlying inflation would not be much greater than 2%. But the real point of this proposal is to excuse a SHIFT from 2% to 4%, and the transfer of wealth from creditors to debtors that this would involve. It is not big thinking, it is dishonest thinking. Moreover, it is also unwise thinking, because it is the bias in favour of debtors that got us into our present mess in the first place. Blanchard should be sent packing from the IMF back to some academic position where he can express provocative ideas without any responsibility.

Posted by: RebelEconomist | February 17, 2010 at 01:31 PM

Hello all, first time posting. This is a great website with intelligent topics and discussions. If someone could please help me understand the above article and comments. Are we discussing how much further, and to what extent the Fed should artificially manipulate interest rates? Are we trying to find a model for the "correct" artificial rate? In all seriousness, why don't we let the market determine what the interest rate should be?

The original post says this:

"The Federal Open Market Committee moved the federal funds rate target to its effective lower bound (0 to ¼ percent) on Dec. 16, 2008. After a very rough start to 2009, gross domestic product (GDP) growth improved substantially in the second quarter. By the third quarter, growth was positive and, as far as we currently know, clocked in near 6 percent in the fourth. Is this the stuff of zero bound disaster?"

Based on your paragraph quoted above, I think we would both agree that the Fed Funds rate is a powerful tool. Simply, if the economy slows down, lower the rate, more money, more elasticity; if the economy heats, raise the rate, less money, more expensive.
Looking at a Fed Funds chart, rates were lowered from January 2001 until August 2004, remaining under 2% for roughly 3 years, one of those averaging around 1%. Around September of 2004 rates started to climb, finally resting above 5% in March 07. We know the history since then.

Is it possible that the low rates from 01-04, and then the higher rates from 04-07 helped greatly to cause the situation we are in now? After all these years of working papers, models, assumptions, policy tools, and targets, we have yet to find anything smarter than the market itself. In my opinion, this paper on a new targeted inflation rate is laughable, it’s similar to the IMF's Guillermo Calvo paper "Is Inflation Effective for Liquidating Short-Term Nominal Debt?” If inflation is so fantastic for the economy, why don’t they give every person in America a counterfeit machine? Our GDP would be off the charts.

The inflation target paper raises a good question, if person is not happy with a 4% inflation target rate, shouldn’t the same person be unhappy with a 2% inflation rate?

To drive my point home, why are we trying to create answers for an interest rate that the market provides already?

Posted by: WilliamATL | February 17, 2010 at 04:06 PM

This has already been tried implicitly in the United States by watering down the inflation measures over the last thirty years to allow the Fed more room to keep an easy monetary policy. If the CPI had incorporated real estate inflation, market rates would've been higher and the Bush administration would've been less inclined to propose so much unwise and wasteful spending and tax cut programs.

Posted by: Les | February 17, 2010 at 07:50 PM

Better not to target any fixed rate but to adapt it to changing circumstance. When long term rates fall below their long term average indicating an increase in leverage, allow inflation to rise. When long term rates rise above their long term average indicating too much inflation, allow it to fall.

Posted by: Lord | February 18, 2010 at 03:15 PM

Great post. Anyone think the Federal Reserve needs to be audited?

Posted by: uspiggybank | February 18, 2010 at 06:25 PM

The inverse correlation between growth and inflation at rates above 2 is hardly surprising, even to a Blanchardian inflationist like me. Imagine a world where all nations follow passive monetary policies, perhaps increasing reserves at a certain fixed rate over time. The functions that relate reserves to nominal demand are mostly a lot of noise, but, taking the path of nominal demand as given, the function that relates inflation to growth is quite precise, and of course the relation is inverse. In this thought experiment, there is no reason to suppose an independent role for the inflation rate in determining growth. Rather, growth is determined primarily by growth in productive potential, and the inflation rate is a residual.

The real world may be different. Monetary policy is seldom entirely passive, and sometimes central bankers do achieve their intentions. But if you look at inflation and growth and ask which one should be treated as exogenous, it seems to me that growth is the obvious candidate. The supposedly active intentions of central bankers are often conditioned by growth expectations. (Surely, for example, a large part of the reason that the Greenspan Fed was able to maintain such low inflation rates in the period after 1995 was that high growth rates removed political pressure for inflationary policies, while a large part of the reason that the Miller Fed tolerated high inflation rates was political pressure resulting from the growth slowdown.)

Posted by: Andy Harless | February 18, 2010 at 07:23 PM

I am afraid the folks at Angry Bear, and Krugman have another agenda that a higher inflation rate plays into.

I think that first you start with the idea of stable monetary policy. Deflation is terrible, but inflation is also bad. Taylor does the best job of putting a rule to it.

As you say, there is a strong correlation between inflation rates higher than 3% in developed economies and negative effects in the economy. Rational people "get" that.

Clearly, the fiscal policy of this administration, and the administration before that was inflationary. The Fed policy has been inflationary as well, because it had to be.

Going forward, we need far better fiscal policy. It will allow the Fed to concentrate on the inflation picture and not concentrating on being the banker of last resort.

Posted by: Jeff | February 18, 2010 at 10:47 PM

Anybody catch the mistake in Friday's CPI report? The Shelter component of the CPI, which has a 32 percent weighting, was calculated incorrectly from the sum of its own components. This seems to indicate that someone at the BLS edited this field to override the calculation. Shelter inflation should have been 0.1 instead of -0.5. The CPI should have been 0.5, not the 0.2 that was reported.

Posted by: Les | February 22, 2010 at 11:55 AM

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