Paul Krugman has a paper that suggests we need a higher inflation target. It’s hard to disagree with these arguments:
First, recent research and discussion of the possibilities of “secular stagnation” (Krugman 2013, Summers 2013) and/or secular downward trends in the natural real rate of interest (IMF 2014) suggests not just that the probability of zero-lower-bound episodes is higher than previously realized, but that it is growing; an inflation target that may have been defensible two decades ago is arguably much less defensible now.
Second, there are actually two zeroes that should be taken into account in setting an inflation target: downward nominal wage rigidity isn’t as hard a constraint as the interest rate ZLB, but there is now abundant evidence that cuts in nominal wages only take place under severe pressure, which means that real or relative wage adjustment becomes much harder at low inflation. Furthermore, we now have reason to believe that the need for large changes in relative wages occurs much more frequently than previously imagined, especially in an imperfectly integrated currency union like the euro area, and that such adjustments are much easier in a moderate-inflation environment than under deflation or low inflation.
Finally — and this is the main new element in this paper — there is growing evidence that economies entering a severe slump with low inflation can all too easily get stuck in an economic and political trap, in which there is a self-perpetuating feedback loop between economic weakness and low inflation. Escaping from this feedback loop appears to require more radical economic policies than are likely to be forthcoming. As a result, a relatively high inflation target in normal times can be regarded as a crucial form of insurance, a way of foreclosing the possibility of very bad outcomes.
This is also very good:
Much of the modern literature on both the zero lower bound and the risks of deflation has its origins in Japanese experience in the 1990s, which led a number of economists (notably Ben Bernanke, Lars Svensson, Michael Woodford, and myself) to worry that something similar could happen to advanced Western economies – which has in fact happened. One characteristic of that early literature was that it involved quite a lot of hectoring, in the sense of Western economists lambasting the Bank of Japan for its inadequate response to low growth and deflation. Bernanke memorably declared that the BoJ needed to start showing “Rooseveltian resolve.”
However, a funny thing happened a decade later: Western central banks also proved diffident in their response to poor economic performance. It seems that entering a slump with low inflation doesn’t simply leave economies vulnerable to an economic trap; it also seems to set central banks up for several kinds of political economy traps, in which officials who promised to act to maintain 2 percent inflation lose their resolve to act when inflation actually drops toward zero.
At the risk of possibly being too cute, let me characterize the various ways in which resolve fails as the complacency trap, the credibility trap, and the timidity trap.
So let’s think about what Krugman has done here. He’s presented an impeccable argument for a higher inflation target. Then he’s explained why the major central banks are unwilling to take his advice. They are complacent and timid. It’s not easy for central banks to abandon a commitment to 2% inflation, and suddenly opt for a 4% inflation target.
But suppose there was another way to address all of the problems associated with the 2% inflation target. A policy that avoided the zero bound problem for interest rates. A policy that avoided the zero bound problem for nominal wage gains. And suppose that policy did not require the central bank to suddenly become bolder when conditions changed. A policy for all seasons, that would be optimal in economies with both high and low growth rates in real GDP. A policy for economies with savings gluts and investment shortfalls.
Fortunately there is—NGDPLT along a 5% trend line. This is roughly (not exactly) the policy the US followed between 1990 and 2007. And if the Fed had announced in 2007 that we would continue to follow this policy in the years to come, no one would have panicked. Both liberals and conservatives would have let out a big yawn—more of the same. And yet in retrospect a policy of 5% NGDP targeting, level targeting, would have prevented (or at least greatly moderated) the Great Recession. To be sure, the policy would probably have been viewed as a failure, especially by those economists representing the party out of office. The poor performance of productivity, labor force growth, etc., was not something that could have been completely avoided (although obviously without a deep recession the labor force would have done somewhat better.) We would have had some stagflation in 2008-2010—low growth and above 2% inflation, which would have been blamed on the change in monetary policy.
Given what we now know I suspect that even Ben Bernanke wishes the Fed had had a 5% NGDPLT policy in 2007. This policy can overcome the wage stickiness problem no matter how much productivity declines. There is no need for the Fed to change policy when conditions change. The rate of inflation automatically adjusts when the trend rate of real growth changes, which is what Krugman is recommending.
Paul Krugman just presented one of the best arguments that I have ever seen for NGDPLT.
PS. The weekly unemployment claims number came in at 297,000. That’s the second lowest figure in 45 years, as a percent of the US population (0.093%). The only lower figure was in April 15, 2000, when it was .092%. Very few workers are losing their jobs, and yet wage growth remains quite low (about 2%.)