The 4% Inflation Target: Two Other Points

May 27th, 2013 at 2:18 pm

I’m a little late to this 4%-inflation-target party set off by the economist Lawrence Ball (whose work shows up here at OTE more than random chance would predict) and picked up by Paul K.

I have a few things to add to the discussion, but first, a very brief recap of this simple, sensible argument.  Ball contends that when the central bank maintains a 2% target, the economy is over-exposed to zero-lower-bound (zlb) risk when we hit a downturn.  Since the real interest rate (r) is the nominal rate (nom) minus inflation (inf), or r=nom-inf, then, as Ball points out, since nom can’t go below zero, the real rate can’t fall below -inf.  In this way, the problem with “…low inflation is that it raises the lower bound on the real interest rate.”

That’s only a danger if the real rate needs to go below –inf, so one important question here is “how likely is that?”  The answer, according to Ball and others, is “more likely than a lot of people think,” and there’s a lot of analysis showing this to clearly be the case in the great recession which we’re still slogging our way out of.

Thus, the danger is not just inflation that’s “too low” such that it invokes zlb risk.  It’s low inflation in tandem with a recession deep enough that we need real interest rates to go well below zero.  One lesson to take from this research is that low inflation and asset bubbles are a particularly toxic combination, and they’re increasingly common.

That “still slogging” point above is important.  Why risk higher inflation just to avoid zlb risk?  Because the zlb is a very serious problem that consigns an economy and the people in it to years of slow growth and high unemployment, QED.  Ball’s suggestion is an insurance policy against that destructive possibility, kind of like suggesting that we put on a few more pounds when the harvests are robust so that when we’re forced to eat less in bad times, we’ll be able to shed a few more pounds without getting sick.

In this analogy, the 2%’ers are imperious dieticians telling us that we’re kidding ourselves if we think we can put on just two more pounds.  Once we breach 2%, we’ll never stop eating, i.e., inflation won’t stop at 4%.  But this is far from obvious.  If the Fed can anchor inflation at 2%, why can’t they do so at 4%?

I’ve got two things to add, the second more important and interesting than the first.

First, I’d make a somewhat analogous case on the fiscal policy side re the (public) debt/GDP ratio: it’s important for the debt/GDP ratio to come down in expansions so that it can go up again in recessions.  I clearly don’t buy the Reinhart/Rogoff stuff about debt thresholds affecting growth but that doesn’t mean we can safely ignore debt ratios.  If the debt ratio remains at the same elevated level it is now, as opposed to coming down once a bona fide expansion takes hold, it will be much harder to convince policy makers of the Keynesian logic that when the next downturn hits, the debt ratio needs to go higher still.

In both this and the 4% inflation case, you want these key economic variables perched such that they can effectively respond to recession.  Inflation needs to be higher than current targets and the debt ratio needs to be lower at the end of the expansion than at the beginning.

Second, in this and other discussions about why we’d want higher inflation, I’ve expressed concerns about real wage growth, especially of low-wage workers.  They’re barely keeping pace with current very low levels of inflation.  Why would anyone who worries about inequality and stagnant earnings advocate a policy that would further lower real wages and incomes?

Because there’s a growth tradeoff on offer here.  The whole point of the higher inflation rates is to generate more growth and lower unemployment.  So the question here is a quantitative one: would the higher inflation generate enough faster wage growth for low- and middle-wage workers to more than offset its impact?

On paper, i.e., based on various standard estimates, the answer is yes.  For example, Ball estimates that had the Fed targeted 4% instead of 2% inflation, the unemployment rate would have come down by two more percentage points, 2010-13.  According to this figure from EPI which maps unemployment changes onto real wage changes,* a two-point decline in unemployment would raise low wages for men by about 4% and for women by about 3%.  Note the much smaller, yet still positive, effects for higher wage workers shown in the figure.

So by these metrics, it’s a worthy trade off and I can stop worrying about whether a higher inflation target will result in lower real earnings for lower-wage workers.  But how realistic are these links in the chain?  They’re plausible—mostly back of the envelope but using standard magnitudes.

On the other hand, the figure below might give you pause.  It plots annual nominal wage growth for low- and middle-wage men (10th and 50th percentiles) against the advocated 4% inflation target (the figure for women looks similar, though their median does a bit better).  Since the mid-1980s, nominal wage growth for these mid- and low-wage men has rarely beat 4%.

At the same time, this is, of course, the period where low-inflation targeting has dominated, so one could argue that this result is kinda baked in the cake.

End of the day, I’d come down with the higher inflation targeters, but I’d keep a very close eye on the real wage trends of the bottom half.  Yes, they very much need more growth and lower unemployment.  But if it doesn’t show up in their real paychecks, it won’t help them.




Source: Economic Policy Institute hourly wage data.

*But doesn’t the graph say “nominal” wage changes on the y-axis?  Yes, but the regression they use to get these elasticities assigns inflation (lagged one period) a coefficient of one—a standard assumption—so that pretty much makes it a regression of real wage changes on unemployment (“pretty much” because of the lag).  Another way of making the same point in the text is that if, as assumed in these regressions, for each point of higher inflation, nominal wage growth goes up 1%, then we don’t need to worry about the impact of higher inflation on real wage growth.

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6 comments in reply to "The 4% Inflation Target: Two Other Points"

  1. Perplexed says:

    -“Because there’s a growth tradeoff on offer here.  The whole point of the higher inflation rates is to generate more growth and lower unemployment.  So the question here is a quantitative one: would the higher inflation generate enough faster wage growth for low- and middle-wage workers to more than offset its impact?”

    Why is it that economists insist on framing this issue as one about growth when the key actors (the plutocrats and their paid-for politicians) are altering the playing field (and protecting their wealth from inflation) on the basis of risk, not growth? As it is with TBTF banks (and corporations in general), the real driver of these decisions is how to protect what you have while laying off the risk of large declines on others (usually the public). In the ongoing game of privatizing the gains while socializing the losses, inflation is the enemy of the wealthy who are trying to preserve the purchasing power of their holdings forward in time to where greater opportunities exist to increase it. Workers bear 100% of the risks of loss of income from unemployment while the wealthy bear none of this risk. Investors “insist” on being compensated for their risks but workers are required to bear the risks of unemployment with no compensation for it. The public bears the risks of corporate failures (beyond the equity of banks and corporations,) and the risks of externalities (e.g. polluted environments and global warming) with little or no compensation from the private actors that extract all of the benefits. As usual, the trade-offs are really about who gets the gains and who bears the risks. Framing it as faster or slower growth simply obscures this reality. The question is really a quantitative one: what are the expected values of the risks, who is bearing them, and who is and isn’t being compensated for the risks born by themselves and those born by others?

  2. Neildsmith says:

    I simply do not understand why or how inflation is magically created. Am I supposed to suddenly demand some product or service that I don’t currently want or need just because the price may go up in the future? The prices of HDTV have gone down with time. The prices of mobile phones have gone down over time. What makes anyone think that it actually possible to generate inflation in a global economy where the costs of production are easily reduced by either outsourcing, automation, or other changes in technology?

    We know what economic growth will look like. All of it will go to the wealthy and the masters of finance on Wall St. It’s been that way for 15 years now.

    • Guest says:

      PY = MV or price level * ouput = monetary base * velocity of money

      Velocity is usually constant, and output is determined by capital and labor. Therefore, when looking at the change, you would get that the change in P is equal to the change in M. Therefore, an increase in the monetary base would therefore lead to an increase in the price level. That is what QE is doing by the fed and bank of Japan to increase inflation.

  3. smith says:

    So otherwise reasonable economists are saying lets have 4% inflation as an insurance policy because the world is embracing austerity contrary to 80 years of accepted wisdom. Because Larry Summers advised against stimulus too big to fail, we should raise the cost of borrowing and housing, depress wages for those with the least leverage, and give monopolies an excuse to raise prices and blame labor.
    I’d be happy with 4% inflation for a few years to reduce debt overhang or if accompanied by significant wage growth, but Krugman and company have no idea how to control spiraling 70s type inflation. Big business raises prices at will because there is no competition, no anti-trust enforcement, the cost of entry is too large, and start-ups get bought up.
    Instead of advocating 4% inflation, how about Obama giving a speech on 4% unemployment. Yes we can?

    • smith says:

      Low interest rates wouldn’t revive a housing market bust, 4% can drop to 0 and still won’t help those actually in need. Look at the number of foreclosures last month compared to pre-2007. 4% wouldn’t prevent the excess of unregulated markets. Where is the evidence that we still wouldn’t reach the zero lower bound in the absence of demand? Why isn’t adequate fiscal stimulus still not the answer? Why aren’t politicians shouting this?

      • Perplexed says:

        -“Why isn’t adequate fiscal stimulus still not the answer? Why aren’t politicians shouting this?”

        Great example of how important it is to ask the right questions! Ultimately they are responding to incentives (as most humans do). They aren’t shouting about it so they can keep their jobs. By not responding, they 1. keep the campaign and superpac funds rolling in & 2. prevent these funds from being used against them by their opponents. Why would we expect any different response?

        The actual mechanics of it are explained in Bob Kaiser’s book “So Damned Much Money”