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On Milton Friedman's "Optimal Rate of Deflation" Argument...

What Should the Inflation Target Be?

Economist Debates: Inflation: Statements: First, the question is not whether the Federal Reserve should raise its target inflation rate above 2% per year. The question is whether the Federal Reserve should raise its target inflation rate to 2% per year. On Wednesday afternoon, the Federal Reserve chairman, Ben Bernanke, stated that he was unwilling to undertake more stimulative policies because "it is not clear we can get substantial improvements in payrolls without some additional inflation risks". But the PCE deflator excluding food and energy has not seen a 2% per year growth rate since late 2008: over the past four quarters it has grown at only 0.9%. At a 3.5% real GDP growth rate, unemployment is still likely to be at 8.4% at the end of 2011 and 8.0% at the end of 2012—neither of them levels of unemployment that would put any upward pressure on wage inflation. It thus looks as though 1% is the new 2%: on current Federal Reserve policy, we are looking forward to a likely 1% core inflation rate for at least another year, and more likely three. A Federal Reserve that was targeting a 2% per year inflation rate would be aggressively upping the ante on its stimulative policies right now. That is not what the Federal Reserve is doing. Would that we had a 2% per year inflation target.

But if we were targeting a 2% inflation rate—which we are not—should we be targeting a higher rate? I believe that the answer is yes.

To explain why, let me take a detour back to the early 19th century and to the first generations of economists—people like John Stuart Mill who were the first to study the industrial business cycle in the context of the 1825 crash of the British canal boom and the subsequent recession. Mill noted the cause of slack capacity, excess inventories and high unemployment: in the aftermath of the crash, households and businesses wished to materially increase their holdings of safe and liquid financial assets. The flip side of their plans to do so—their excess demand for safe and liquid financial assets—was a shortage of demand for currently produced goods and services. And the consequence was high unemployment, excess capacity and recession.

Once the root problem is pointed out, the cure is easy. The market is short of safe and liquid financial assets? A lack of confidence and trust means that private-sector entities cannot themselves create safe and liquid financial assets for businesses and households to hold? Then the government ought to stabilise the economy by supplying the financial assets the market wants and that the private sector cannot create. A properly neutral monetary policy thus requires that the government buy bonds to inject safe and liquid financial assets—what we call "money"—into the economy.

All this is Monetarism 101. Or perhaps it is just Monetarism 1. We reach Advanced Macroeconomics when the short-term nominal interest rate hits zero. When it does, the government cannot inject extra safe and liquid money into the economy through standard open-market operations: a three-month Treasury bond and cash are both zero-yield government liabilities, and buying one for the other has no effect on the economy-wide stock of safety and liquidity. When the short-term nominal interest rate hits zero, the government has done all it can through conventional monetary policy to fix the cause of the recession. The economy is then in a "liquidity trap".

This is not to say that the government is powerless. It can buy risky and long-term loans for cash; it can guarantee private-sector liabilities. But doing so takes risk onto the government's books that does not properly belong there. Fiscal policy, too, has possibilities but also dangers.

My great uncle Phil from Marblehead, Massachusetts, used to talk about a question on a sailing safety examination he once took: "What should you do if you are caught on a lee shore in a hurricane?" The correct answer was: "You never get caught on a lee shore in a hurricane!" The answer to the question of what you should do when conventional monetary policy is tapped out and you are at the zero interest-rate nominal bound is that you should never get into such a situation in the first place.

How can you minimise the chances that an economy gets caught at the zero nominal bound where short-term Treasury bonds and cash are perfect substitutes and conventional open-market operations have no effects? The obvious answer is to have a little bit of inflation in the system: not enough to derange the price mechanism, but enough to elevate nominal interest rates in normal times, so that monetary policy has plenty of elbow room to take the steps it needs to take to create macroeconomic stability when recession threatens. We want "creeping inflation".

How much creeping inflation do we want? We used to think that about 2% per year was enough. But in the past generation major economies have twice gotten themselves stranded on the rocks of the zero nominal bound while pursuing 2% per year inflation targets. First Japan in the 1990s and now America have found themselves on the lee shore in the hurricane.

That strongly suggests to me that a 2% per year inflation target is too low.

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