The Jackson four
Should the Fed adopt India’s inflation target?
IN THE latter part of this week, monetary policymakers and theorists from around the world were due to attend the Jackson Hole symposium, 6,800 feet up in the mountains of Wyoming.
Many people—aggrieved savers and yield-hungry investors—probably wish they would never come back down. To their critics, central bankers seem strangely committed to two unpardonable follies: eroding the interest people earn on their savings and inflating the prices they pay at the shops.
It was, therefore, brave of one central banker—John Williams of the Federal Reserve Bank of San Francisco—to argue on August 15th that the Fed might need to raise its 2% inflation target or replace it with an alternative if it is successfully to fight the next downturn. Some economists favour an inflation target of 4%. This is not as outlandish as it sounds. Indeed, the notion that new circumstances require a new target may appear quite run-of-the-mill to central bankers from the developing world who are taking part in the symposium.
Much criticism of the West’s central bankers rests on the myth that they are wholly responsible for rock-bottom rates. In fact, they seek the highest rates the economy can bear, but no higher.
When the economy is at full strength, they want a “neutral” (or natural) rate that keeps inflation steady, neither stimulating the economy nor slowing it. When the economy is overheating, they want a rate above neutral. And when the economy is weak, they want one below it. The neutral rate (r* in economists’ algebra) thus provides a vital reference point for their policy. As such, it exercises considerable influence over central bankers. But they, importantly, exercise precious little influence over it.
According to economic theory, the neutral rate reconciles the eagerness to invest and the willingness to save when the economy is in full bloom. As such, it reflects the productivity of capital, the promise of technology and the prudence of households, none of which are variables chosen by monetary officials. The neutral rate cannot be observed directly. But Mr Williams and a Fed colleague reckon it has fallen persistently: r-star (as he calls it) is close to zero, or about two percentage points lower than it was in 2004.
If r-star is lower than it was back then, the Fed’s policy rate must also be lower to be equally stimulative. That means today’s rate (of between 0.25% and 0.5%) is not as lax as it looks. Leo Krippner of the Federal Reserve Bank of New Zealand estimates that American monetary policy today is already as tight as it was in July 2005, when the federal funds rate stood at 3.25%, having been raised nine times.
The question preoccupying most Fed-watchers is how much tighter policy will get in the next year or two. Mr Williams raises a different concern: how much looser can policy get during the next downturn. If the Fed sticks to its current inflation target of 2%, a policy rate of 0% would translate into a real cost of borrowing of minus 2% (because the money debtors repay will be worth less than the money they borrowed). That may not be low enough.
Such a rate would be only about two percentage points lower than Mr Williams’s estimate of the neutral rate. Raising the inflation target to 4%, say, would allow real interest rates to drop about four percentage points below neutral if necessary. (This is not the only reform idea.
Another is targeting the trajectory of nominal GDP, which reflects both economic growth and price inflation; that might result in higher inflation when growth was weak and low inflation when growth was strong.)
But even if a 4% target is desirable, would it be feasible? The Fed has struggled to reach its current target quickly or consistently. What makes anyone think it could hit a higher one? One answer is that a higher target would free the central bank from a “timidity trap”, as Paul Krugman of the New York Times calls it. In such a trap the central bank sets its goals too low, and paradoxically falls short of them. A credible central bank might cut rates to zero and promise 2% inflation. If it is believed, inflation expectations will rise and the anticipated real cost of borrowing will fall to minus 2%. But if the economy actually needs a real rate of minus 4% to revive, spending will remain too weak, economic slack will persist and inflation will ebb, falling under target. Conversely, if the central bank promises 4% inflation, its pledges will be both believed and fulfilled.
Although a target centred on 4% sounds scandalous to rich-world central bankers, it is not unusual elsewhere. Indonesia pursues one. Brazil’s inflation target is 4.5%. India is lowering its target from 6% last year to about 4% for the future. The committee recommending that figure was chaired by Urjit Patel, who will be the Reserve Bank of India’s next governor.
One advantage many emerging economies enjoy over richer ones is a higher r-star, thanks to faster rates of underlying growth and inflation, as low local prices converge towards higher international prices. That gives their central banks more room to cut interest rates in the face of a downturn. Indeed, it is hard to think of any catch-up economy that has remained stuck at zero rates.
If Mr Patel succeeds in his new job and the Fed embraces reform, America’s inflation target may one day resemble India’s. But India will still worry more about overshooting its target than undershooting it, and America will still probably harbour the opposite set of concerns.
Their inflation targets may match, but their r-stars will not be aligned.