Central banks took the wrong end of inflation


It’s certainly not by saying you are going to keep interest rates near zero–at the zero lower bound or ZLB–for “an extended period”, like the Fed and now the BoE and the ECB are conveying, that you effectively do it. The consequence of that sort of “forward guidance” is that you get everyone trying to guess the day that it ends. In the interim what you observe is a lot of market volatility. Just look at how stock and foreign exchange markets have behaved since last May when the ‘tapering’ talk began.

It is also an impossible task to accomplish if, as those geniuses have done, you keep reminding everyone that your inflation target is unassailable!

An alternative, which has been proposed by people like Krugman and Blanchard, is for the central bank to increase the inflation target. But that’s a no no!

In this post, Nick Rowe clearly explains the solution, and it is “easy to sell”: “Simon could try to convince my mother to move along the inflation targeting curve to a higher inflation target to reduce the risk of hitting the ZLB. He could try to explain to her that higher inflation caused by looser monetary policy (and not by all those other things that Mother thinks may cause inflation) would cause nominal income growth to rise at least in proportion to higher inflation (though in Mother’s case it probably wouldn’t) and would even rise by more if this reduces the ZLB risk. But Simon knows he would have a difficult job ahead, even though he has never met my mother.”

“Or he could try to persuade Mother that it would be a good thing if the Bank of England made people’s incomes grow at (say) 5% per year, acknowledge that making people’s incomes grow any faster might simply cause inflation to rise equally faster too, and happily agree with Mother that inflation really is a bad thing that makes people worse off. And if he added that he wants to do this because it would reduce the risk of her getting 0% interest on her savings account, I think he would get her vote (but maybe he shouldn’t mention badgers).”

“Sometimes, just sometimes, policies that are economically right are also easier to sell politically. This is one of those times.”

The harder and more controversial task would be to establish the target level for nominal GDP and the time frame to reach it after which the x% program would follow, but that’s far from impossible to ascertain.

About the Author

Marcus Nunes
João Marcus Marinho Nunes is a partner of Phynance Estratégias Quantitativas e Investimentos and a professor of Economics at Fundação Getúlio Vargas in São Paulo, Brazil. He also blogs here: http://thefaintofheart.wordpress.com/

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