As inflation in the U.S. has struggled to get back to 2%, there has been much debate on whether there needs to be an inflation targeting change. I will not outline all of the alternatives (though a good summary can be found here). Rather I will reflect on a few major points of the debate.
Higher inflation is a good thing, right?
One benefit of higher inflation is the ability for consumers to crawl out of debt. This is beneficial because consumers have binged on debt since the financial crisis and the additional debt will pose a problem in the near future. So, having a higher inflation target can benefit consumers (and governments). However, how much control do central banks (CBs) have over inflation? In a bubble, CBs can control inflation with ease. CBs can simply let inflation run to, say, 5% per year and when this gets tiresome they can reel it in. But the real world does not function in a bubble. Consumers make irrational (well, rational to them) decisions and change these decisions on a daily basis. If CBs targeted higher inflation, say, my arbitrary 5%, consumers will shift their purchases forward with the presumption that tomorrow the price of the good will be higher. This would drive prices higher and inflation even higher. Over time, hyperinflation may kick in. Now, in that Utopian bubble, CBs could very easily step in when inflation hits 5.1% and break the cycle. But, again, the world is not a Utopian bubble. It takes time for monetary policy to filter through the economy.
The consequence of a higher inflation target is – in the likely event of a policy mistake (i.e. the CB waiting too long to raise rates) – inflation will overshoot. If inflation overshoots a 2% target by 1%, this is fine. If it overshoots the arbitrary 5% target by 50%, then inflation hits 7.5%. That can cause more problems than having a 2% target.
But the past always repeats itself, right?
Another issue is that all of the studies that recommend increasing the inflation target are based on historical information. In other words, there is a lack of respect for radical uncertainty. In other words, short-term interest rate cuts have been used to stabilize recessions in the past, so we need to use those going forward. By lowering short term interest rates, the CB can spur businesses and consumers to spend more as rates across the term structure decrease. Thus, being at or near the zero lower bound (ZLB) moots this policy tool. This logic assumes that all recessions are created equal; which is not true. This also assumes that there are infinite viable business investments. This is not true either. Firm’s commit capital when it is profitable to do so (i.e. positive NPV). The lack of viable business investments has been one of the problems with this economic cycle. Large firms have simply used cheap debt to repurchase outstanding shares and manipulate EPS.
The real paradox here comes from the fact that to target higher inflation you need significant fiscal stimulus to push aggregate demand up (very difficult in today’s partisan world) or CBs need to keep real rates low to increase business investment, increase wage inflation, and eventually increase headline inflation. Did you catch that? If the goal is to get away from the ZLB, keeping rates low for longer does exactly the opposite. You would effectively hope inflation speeds up well past the new >2% target giving you time to raise rates significantly all before the next recession. I’m as optimistic as the next guy, but this is hopeful thinking.
This all assumes a low inflation and low growth world is a bad thing. A low growth and low inflation economy has benefits. An economy with slower growth has weaker recessions. In other words, if an economy grows at an annualized rate of 5% per year for five years, the contraction might be, say 5% in six months. An economy that grows 3% per year for five years might only see a measly 1% decline in GDP during the contraction. The high growth economy may see tens of millions of jobs lost. The low growth society will, for the most part, carry on. By moving to a higher inflation world, we are effectively committing to a high-powered economy with significant booms, busts, and bubbles. While the 2% target may be arbitrary to some and may cause a liquidity trap for highly indebted individuals, it helps to minimize spectacular booms and busts. Think of it as a risk mitigation strategy.
OK, so why has employment and productivity been so low?
Some have argued that we do not need to change the 2% target because the CB has many tools to stabilize an economy, even at the ZLB (Mankiw and Weinzierl 2011). The rethink 2% group responds to this with questions asking why employment has been low and productivity weak if these other tools work? The unemployment aspect of this is simple. Historically, the employment situation is fine. Below is the chart for U-6; which is the total unemployed, plus all persons marginally attached to the labor force, plus total employed part-time for economic reasons. This is generally a more robust gauge of employment than the headline unemployment rate.
As you can see, we are almost back to the pre-financial crises level.
Using the less robust, but longer sample sized civilian unemployment rate, you see we are about where we should be at this stage in the economic cycle. In fact, using the 1980s as a precedent, it is almost identical. So while I am sticking my foot in my mouth after my statements about “don’t look into the past too much,” the claims that employment is low are overblown and grossly exaggerated.
Productivity on the other hand, is a different topic. There are consequential reasons why productivity has been depressed since the financial crisis. The primary reason is business growth – that is, new businesses entering the economy – still has not picked up. As an aside, I am currently working on a paper developing a tool to calculate “entrepreneurialism.” Back on topic now. As you can see below, the total number of entrepreneurial firms has dropped precipitously. I define an entrepreneurial firm as one that has a firm age of 5 years or less.
This is the primary reason productivity has been low. What is causing the trend? Well, there are a few reasons. First off, student loans are holding back the individuals in the entrepreneurial stage of their life from starting new ventures. If you have student loans, you must have a steady job that pays a salary to pay off those loans. Without the student loans, new bright ideas can blossom (I will move on from here before I digress into a novel about student loan drag). The second reason is that many consumer balance sheets were crushed by the financial crisis. Assets that could have been used to start a business were wiped out. And lastly, tighter loan provisions from banks are likely not allowing some great ideas to hit the market.
We are beginning to see the inkling of higher inflation. Meaning, monetary policy might end up working just fine; just not as fast as many would like. Wage inflation is typically the initial sign that higher inflation is on the way. The problem is that it is very weak and taking “too” long.
This comes back to the title of this post; which is that economists must not think too hard. Radical uncertainty – of which the economy is a prime example – tells us that any given day the historical trend can change. Economists are looking at the past and asking why is it not happening today. The answer is simple: the economy is not predictable. I do agree policymakers should be flexible, but there are better ways to attack low inflation than changing the CBs inflation target.