Optimal Inflation

Paul Krugman takes issue with the Fed's now more-or-less-explicit long-run inflation target of 2%. He thinks it should be 4% or 5%.

Here's the offending part of his blog post:

But why is the inflation target only 2 percent?

Actually, I understand why; the inflation hawks are still a powerful force that must be appeased. But the truth is that recent experience has made an overwhelming case for the proposition that the 2 percent or so implicit target prior to the Great Recession was too low, that 4 or 5 percent would be much better. Even the chief economist at the IMF says so. (OK, in real life it’s Olivier Blanchard, who is a very smart and also flexible-minded macroeconomist who just happens to be at the IMF for now — and I’m glad that he is!)

Comments:

1. The "inflation hawks" are NOT a powerful force on the FOMC. The Committee just voted, with one dissenting vote, to keep the target for the fed funds rate in the range 0-0.25% until the end of 2014. That's hardly a hawkish policy, and the Fed has already engaged in some massive and unprecedented quantitative easing, that is far from hawkish and conservative. Indeed, it is quite risky, and favored by the majority of FOMC members, who are basically old and new Keynesians, if they know any economics at all. Actually, the moniker I would prefer to apply to the "inflation hawks" is "serious economists" (for the most part - Fisher is not an economist).

2. The Blanchard paper that Krugman is referring to is this one. Here is what it says about the central bank's inflation target:

The crisis has shown that large adverse shocks can and do happen. In this crisis, they came from the financial sector, but they could come from elsewhere in the future—the effects of a pandemic on tourism and trade or the effects of a major terrorist attack on a large economic center. Should policymakers therefore aim for a higher target inflation rate in normal times,
in order to increase the room for monetary policy to react to such shocks? To be concrete, are the net costs of inflation much higher at, say, 4 percent than at 2 percent, the current target range? Is it more difficult to anchor expectations at 4 percent than at 2 percent?

The paper goes on to discuss the costs of the inflation, in more-or-less standard textbook terms. There's nothing new there. So, did Krugman actually read the paper or not? It doesn't really matter. The key point is that Blanchard is not recommending anything, he's just asking a question. There's no report on any research to answer the question; this is just Blanchard musing with his staff about how recent history might change how we think about monetary policy. Thus, Krugman's statement that "Even the chief economist at the IMF says so," is false.

But what of Krugman's argument? Krugman says (repeating the above):

But the truth is that recent experience has made an overwhelming case for the proposition that the 2 percent or so implicit target prior to the Great Recession was too low, that 4 or 5 percent would be much better.

He certainly seems convinced; "truth" and "overwhelming" are strong words. It's hard to see why, though, and he doesn't tell us. If you read Blanchard's paper, and look for the reasoning, you might see what Krugman has in mind. The basic idea is that a higher inflation rate gives the central bank more room to move. By Fisherian logic, if the real interest rate is constant in the long run, and the long-run Fisher effect holds, the long-run nominal interest rate will rise one-for-one with the long-run inflation rate. Having more room to move means that, if you subscribe to New Keynesian logic, then if the long-run inflation rate is 4% rather than 2%, on average you have an extra 2% by which you can lower the central bank's nominal interest rate target so as to correct sticky price distortions. There are at least 3 problems with this:

1. This presumes that the long-run costs of inflation are negligible, but to me this looks like an argument for wearing a sweater in July. You can always take it off if you want to cool down. I have written more on the costs of inflation here. Potentially the long-run costs of inflation are much larger than conventionally measured. Anyone who lived through the 1970s or, even better, comes from a country with a serious inflationary history, understands that inflation is bad.

2. If the key macroeconomic inefficiencies we are faced with are the relative price distortions coming from sticky prices, those inefficiencies might more appropriately be corrected with fiscal policy than monetary policy. Krugman seems to be thinking that the zero lower bound is a big problem, but the zero lower bound need not bind.

3. Blanchard, like Krugman, seems to fear the zero lower bound because bad stuff can happen there. Well, we have been in our modern-day liquidity trap for more than three years now, and apparently we have not yet been sucked into the deflationary vortex with ever-increasing output gaps that these characters seem to be concerned with.