ï»¿Inflation Targeting in a Deflationary World
Marc recently noted the Bank of Canadaâ€™s announcement that it was cutting interest rates to increase future inflation up to the 2% target. In the comments section, Stephen argued that there is nothing noteworthy about the Bank trying to achieve this target. Everyone else contended that the Bankâ€™s new line deviates significantly from its previously hawkish position on inflation.
It strikes me that the Bankâ€™s longstanding inclination toward below-target inflation is not a matter of conjecture. Arun pointed to the IMF study. I would point to the Bankâ€™s own research/consultation program on inflation targeting:
The research program will focus on two broad sets of questions:
What are the costs and benefits of an inflation target lower than 2 per cent? Would an inflation target lower than 2 per cent generate significant net benefits for the economy and for Canadian households?
What are the costs and benefits of replacing the current inflation target with a longer-term, price-level target? Would a price-level target produce significant net benefits for the economy and for Canadian households?
There is apparently no possibility of discussing a target higher than 2%. The Bankâ€™s instincts are (or were) quite explicitly in the direction of an even tighter inflation-rate target or price-level target.
The Bankâ€™s effort to explain current policy in terms of inflation targeting is somewhat contrived: “further monetary stimulus will likely be required to achieve the 2 per cent inflation target over the medium term.” The main purpose of “further monetary stimulus” is not to ensure a nominal inflation rate of 2% rather than 1% in 2009, but to stimulate the deteriorating real economy. The Bank has invoked the prospect of below-target inflation in 2009 to fit current interest-rate reductions into its inflation-targeting framework.
Of course, keeping inflation positive to avoid deflation is a worthy objective. However, a target of precisely +2.0% has no particular merit in that regard.
True, the Bank would prefer a target of less than 2% and is interested in targetting the price level. However, in fairness, I think you will find that inflation has averaged out at almost exactly the target rate since the target was set, so they are governed by their mandate rather than by their preferences (which might now change given the postive role inflation can play in resolving debt crises.)
The main purpose of â€œfurther monetary stimulusâ€ is not to ensure a nominal inflation rate of 2% rather than 1% in 2009, but to stimulate the deteriorating real economy.
Those statements are equivalent. A deteriorating real economy will lead to inflation below its target, so the bank will cut interest rates. That’s the same thing as saying that an improving real economy will lead to inflation above its target, so the Bank will raise interest rates.
And indeed, there’s nothing special about 2%. It could be 1%, or indeed 0. The reason why it’s positive is that the CPI is a Lasperyes index, and it has a positive bias: setting the target too low could run the risk of deflation.
Does anyone have a theory explaining why progressives should favour higher inflation? Because I really can’t think of one.
Well, there is Pierre Fortin, who has articulated the view that the 2% target is too tight:
Fortin, Pierre. 2001. “Inflation Targeting: The Three Percent Solution.” Policy Matters 2: no.l, Institute for Research on Public Policy.
Sure, but that argument is based on a story in which nominal wages are rigid/sticky, and the role of higher inflation is to reduce real wages. Lower real wages leads to higher employment as we move down the firm’s laour demand curve..
I have two problems with that analysis:
1) We’re at record levels of employment, so I don’t see the point of eroding real wages to increase employment.
2) Why are lower real wages progressive?
“Lower real wages leads to higher employment as we move down the firmâ€™s labour demand curve..”
Who knew it was lower real wages driving employment growth in Alberta over the last decade? I am still chuckling.
The point was that lowering real wages is the only way that central banks can increase employment. Happily, there are other mechanisms for job creation.
“Happily, there are other mechanisms for job creation.”
Like reducing the interest rate?
Has nobody read Schumpeter here? Why do you want higher inflation: it is called inflation-induced growth, or creating the monetary illusion.
Concern about deflation is a pretext. I worked 40 years in the computer industry and the cost of a computing cycle deflated every single year. The last computer that I purchased for $400 is more powerful and convenient than the one I purchased 20 years ago for $4000. Is computer manufacturing in crisis?