Better to undershoot a 3% target than overshoot a 2% target

I have pretty similar views on monetary policy as Ryan Avent, but I’m going to quibble slightly with this:

At the same time, a period of inflation above the Fed’s 2% target would give the central bank more headroom to raise its benchmark interest rate. The higher the level of long-run nominal rates, the less likely rates are to fall back to zero the next time trouble strikes.

Back in 2009, 2010, 0r 2011, it would have made sense to try to overshoot the 2% inflation target.  But not today, with unemployment at 4.6%.  If we pushed inflation above 2% when the economy is strong, then we’d have to shoot for under 2% inflation when the economy is weak.  We’d be more likely to fall back to zero next time.

Indeed this is basically what went wrong in 2008.  Inflation exceeded 2% during the housing boom.  Thus when the Fed needed to move aggressively to ease policy in 2008, they held back in fear of inflation (which ran above 2% during 2008).  It would make more sense to shoot for below 2% inflation during booms, and above 2% inflation during recessions.

Ryan does have some forceful arguments for higher inflation, but I think they’d be more effective if couched in terms of a change in the inflation target.  Thus instead of calling for an overshoot of the 2% target by 1/2%, it would make more sense to call for undershooting a new and higher 3% inflation target, by 1/2%.  Increasing the inflation target to 3% would indeed give the Fed more room to cut rates in the next recession, in a way that overshooting the 2% target would not.  In addition, undershooting the target during a boom is more consistent with the spirit of NGDP targeting, which Ryan has previously endorsed.

This all might seem like a meaningless quibble; “What difference does it make what we do to the target, as long as we get 2.5% inflation.”  In the very short run it may make no difference.  But if you don’t make monetary policy decisions in the context of a clearly defined policy regime, then the economy is likely to be less stable, especially when we reach a turning point in the business cycle.

As always, this 3% inflation target is not my preferred option (I prefer NGDPLT). I’m just trying to illustrate what I think is the most fruitful approach for people with current views on policy that might be described as “dovish.”


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31 Responses to “Better to undershoot a 3% target than overshoot a 2% target”

  1. Gravatar of Rajat Rajat
    1. January 2017 at 23:47

    I see three issues. They all relate in one form or another to the interpretation of the dual mandate.

    First, you have suggested on numerous occasions that the dual mandate only makes sense if it means higher-than-target inflation during recessions and lower-than-target inflation during booms. This makes sense if you are referring to supply-side-driven booms and recessions, but is that what you mean? The way it is expressed in this post, it sounds like you are referring to demand-side booms and recessions. But that would be oxymoronic – how can one have low (demand-side) inflation during a (demand-side) boom?

    Second, I think that many financial commentators interpret the dual mandate as an objective of minimising a ‘misery index’ of the inflation rate plus the unemployment rate. Therefore, the dual mandate is regarded as supporting below-target inflation during recessions when UnN is high. This goes back to the flawed but commonly-held view that inflation is always and everywhere a ‘bad thing’ per se, so lower inflation is always better, as long as it is still positive. Importantly, this misconception suits central bankers, because it allows them to be less accountable for policy errors.

    By the way, I’m not saying Ryan holds any of the above views; just that I think they are widespread.

    The third issue is my guess about where Ryan’s thinking lies – that the Fed simply won’t allow inflation to run high during negative supply shocks, and encouraging the Fed to run higher inflation during booms will not inhibit them from loosening policy if required during a negative demand shock. Rather, higher inflation (and eventually, higher nominal interest rates) during a boom will allow central bankers more room to cut rates, given central bankers’ apparent aversion to low (or negative) nominal policy interest rates. Even central bankers like Bernanke who once did not hold these views grow to hold them when taken by the Fed borg. And a higher inflation target is not politically palatable. So in a realpolitik sense, overshooting the inflation target is better than not.

  2. Gravatar of ssumner ssumner
    2. January 2017 at 07:27

    Rajat, You said:

    “The way it is expressed in this post, it sounds like you are referring to demand-side booms and recessions. But that would be oxymoronic – how can one have low (demand-side) inflation during a (demand-side) boom?”

    “Demand” is just another word for monetary policy. So I’m saying that you should try to avoid demand side recessions, as that would violate the dual mandate.

    You said:

    “Second, I think that many financial commentators interpret the dual mandate as an objective of minimising a ‘misery index’ of the inflation rate plus the unemployment rate.”

    That may be true, but it’s not the Fed’s policy, which calls for a symmetrical inflation target. Otherwise the Fed policy would be “ever lower inflation”, not 2% inflation. I am confident that the Fed itself does not suffer from this misconception.

    You said:

    “The third issue is my guess about where Ryan’s thinking lies – that the Fed simply won’t allow inflation to run high during negative supply shocks, and encouraging the Fed to run higher inflation during booms will not inhibit them from loosening policy if required during a negative demand shock.”

    I’m not sure if this is his thinking, but it’s not correct. First, the Fed does allow above target inflation during supply shocks, a good example is the first 6 months of 2008.

    Second, encouraging the Fed to run higher inflation during booms would inhibit their ability to loosen monetary policy during recessions. That’s because by definition if inflation is above average during booms, it must be below average during recessions. And if you have below average during recessions, that’s a tighter monetary policy than above average inflation during recessions. Ergo monetary policy would be tighter than otherwise.

    Nor will they have more “room” in the sense of a higher Wicksellian equilibrium rate, as the markets will expect lower inflation during a recession, and thus the Wicksellian will fall more sharply.

  3. Gravatar of Major.Freedom Major.Freedom
    2. January 2017 at 11:44

    Sumner, given your multiple prior postings on the meaninglessness of price inflation methodologies and statistics, how can you claim to be making a meaningful distinction between undershooting a 3% price inflation and overshooting a 2% price inflation?

  4. Gravatar of Randomize Randomize
    2. January 2017 at 12:02

    This blog needs a “like” button.

  5. Gravatar of ssumner ssumner
    2. January 2017 at 13:12

    Randomize, This is probably a dumb question, but exactly what is a “like button”? And why do I need it?

  6. Gravatar of Jerry Brown Jerry Brown
    2. January 2017 at 14:46

    I am understanding this post as saying that it is better for the Fed to stick to the wrong target (as in de facto 2% inflation ceiling) than to change its target unannounced even if that change more approximated a reasonable NGDP growth level target.

    Is this a reasonable interpretation? Or am I screwing it up?

  7. Gravatar of ssumner ssumner
    2. January 2017 at 17:45

    Jerry, No, that’s not the way I interpret Ryan’s claim. He was not suggesting that the Fed change their 2% inflation target, but rather temporarily overshoot the target. That’s what I think is a mistake right now (although it would have been completely appropriate in 2010.)

    If they did adopt an unannounced NGDP target that would be fine with me, as it would mean lower than 2% inflation when unemployment is low and higher than 2% inflation when unemployment is high.

  8. Gravatar of Benjamin Cole Benjamin Cole
    2. January 2017 at 19:16

    Well, excellent blogging, but given what seems to be happening all over the developed world, the problem is not inflation but weak aggregate demand and disinflation-deflation.

    Both Japan and Thailand seem to have zero inflation and no or very low unemployment. The Phillips Curve in the USA has been prone for a generation.

    Also, discussions of inflation and monetary policy in the US must necessarily address property zoning, and the role of property in measured inflation, and the role of property in bank lending.

    About 75% of commercial bank lending in the US is on property. It might be more, since lending to small business is often collateralized against property.

    So commercial banks are better regarded as “Property Lending and Commercial Banks”.

    See Kevin Erdmann, and also ponder the endogenous creation of money, when banks have $2 trillion in reserves.

    It is dispiriting that when U.S. orthodox macroeconomists discuss inflation and monetary policy, they immediately turn to the inflation-fighting solution of unemploying people who want to work. Egads.

    How about we first turn to the solution of unzoning property?

  9. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    3. January 2017 at 08:57

    ‘About 75% of commercial bank lending in the US is on property. It might be more, since lending to small business is often collateralized against property.’

    I don’t know how large it is, but I’ve recently been made aware that there is a thriving market in lending by income tax preparers to people due ‘refunds’ on their tax returns. Advertised as no interest loans, but in fact fairly hefty fees for the preparation of the tax return fund it.

    This is the side of the tax credit–EITC, Child Care, Additional Child, Saver’s–industry not publicized by politicians. The market is an amazing thing; information about this is well known to people with low, and even moderate, incomes who qualify for the euphemistically labeled ‘refundable credits’ (aka, free money).

    Something that relates to Scott’s Econlog post on the Finnish experiment on guaranteed income.

  10. Gravatar of Randomize Randomize
    3. January 2017 at 15:40

    The “like” button is a social media reference. Facebook, youtube, etc. have such a feature where the consumer can simply click a button to express their approval. I strongly suspect that most of the people who read one of your posts and think, “That’s a good post and I have nothing more to contribute,” simply move on without commenting while the trolls and nitpickers care enough to comment. Thus, if you’re judging feedback by the comments, you’d have a very skewed view of how people actually feel about your posts.

  11. Gravatar of B Cole B Cole
    3. January 2017 at 16:40

    “For months, despite criticism from President-elect Donald Trump, Ford Motor Co. executives insisted that they would not alter their intention to spend $1.6 billion to build a new factory in Mexico.

    But with Trump poised to be take office and showing no hesitation to use his new clout to publicly pressure companies over their practices, Ford abruptly reversed course.”

    —30—

    Is this really bad news for Americans?

  12. Gravatar of Cooper Cooper
    3. January 2017 at 17:40

    B. Cole,

    Yes, it’s bad news for Americans.

    It means that companies will be reluctant to move their operations to the US for fear that it will be politically impossible to close down those plants if business conditions change.

    If you can’t fire people, you won’t hire people.

  13. Gravatar of Benjamin Cole Benjamin Cole
    3. January 2017 at 18:58

    Cooper:

    Maybe so.

    There is also a larger perspective, that the world has multinational giants that operate in system of negotiated trade agreements (probably helpfully designed by multinationals, at least on the U.S. side). NAFTA is 1,700 pages, for example. How you ever read it? I never have. Is it free trade? Who knows?

    Adding to this uncertain mix are domestic tax laws and regulations, and then more uncertain rules pertaining to placing trillions of dollars (perhaps $30 trillion) in offshore bank accounts. Add about $10 trillion in “hot money” that courses the globe, very liquid, looking for highest yields.

    Usually, the argument made for offshoring operations and consequent large US trade deficits is that the income Americans lose from producing and working is made up by foreign inflows of capital into US assets, especially property.

    Yet this argument runs up against the ubiquitous practice of property zoning, which means that much foreign capital flows into a fixed asset class (often leveraged by American banks), causing property appreciation and lowering living standards for Americans.

    I find free trade theory is just that–a theory. There are extremely intelligent proponents of free trade theory, including of cource Scott Sumner.

    However, there are also highly intelligent people somewhat dubious about the glib platitudes attached to putative benefits of huge US trade deficits.

    Add on:

    “House Republicans pull plan to gut independent ethics committee after Trump tweets”

    You know, this guy Trump is looking better and better….

  14. Gravatar of Ray Lopez Ray Lopez
    3. January 2017 at 20:33

    Sumner: “But if you don’t make monetary policy decisions in the context of a clearly defined policy regime, then the economy is likely to be less stable, especially when we reach a turning point in the business cycle.” – why? Is this some variant of the RatEx view that clearer Fed policy provides beneficial forward guidance? Seems so. Cite please? Other than the lame excuse that expectations are built into the DSGE neo-Keynesian models, as a fudge factor, which is a circular argument.

    Sumner: “As always, this 3% inflation target is not my preferred option (I prefer NGDPLT). ” – yes, but as I’ve pointed out in my poignant prior comments, at some point Sumner’s NGDPLT merges with inflation targeting via interest rates (assuming money non-neutrality). So the poignant [trenchant] question is: if current Fed policy mimics Sumner’s NGDPLT (at times), then what’s the harm? The only harm is my first poignant point above: the absence of clearly articulated Fed policy that adopts NGDPLT. So then the question is, like I said above, ‘so what’? Where is the data that shows uncertainty in Fed pronouncements is bad? Recall Greenspan did just fine (for a long while) making opaque pronouncements, as did Volcker with his doublespeak. Seems Sumner is regurgitating some academic paper from decades ago he read, during the peak of RatEx, about how jawboning expectations are important. Poignant is a word Scott. But I meant trenchant and am too lazy to correct it.

  15. Gravatar of Brian Donohue Brian Donohue
    4. January 2017 at 05:09

    “If we pushed inflation above 2% when the economy is strong, then we’d have to shoot for under 2% inflation when the economy is weak.”

    Isn’t that statement as true as this one?

    “If we pushed inflation below 2% when the economy is weak, then we’d have to shoot for over 2% inflation when the economy is strong.”

    As an empirical matter, the second statement is not true over the past 8 years.

    I agree with you on the desirability of counter-cyclical inflation as a means of stabilizing NGDP and employment, but these things aren’t laws of nature.

  16. Gravatar of SG SG
    4. January 2017 at 16:22

    Scott, it’s hard to focus on macro when Giannis is taking over the NBA…

    Have you read the Lee Jenkins profile yet? Great stuff.

    http://www.si.com/nba/2017/01/03/giannis-antetokounmpo-milwaukee-bucks-greek-freak-jason-kidd

  17. Gravatar of Philo Philo
    4. January 2017 at 16:41

    @ Benjamin Cole:

    You say that foreigners are shopping for real estate in the U.S., causing real property to appreciate (more than it would have otherwise). But how is this “lowering living standards for Americans”? An American who thought his house was worth $200,000 gets bought out by a foreigner for $300,000; is that bad for him? If the foreigner is not going to move here–which will be the usual case–the American may even continue to live in the house as a renter, meanwhile having a lot more money than he expected. Thus Americans who are willing to sell a house will get a windfall because of the foreign demand. True, Americans who want to buy a house will face higher prices, but why buy an overpriced house when you can rent relatively cheaply?

  18. Gravatar of Benjamin Cole Benjamin Cole
    4. January 2017 at 19:14

    Philo:

    Indeed, for those who already own, or can leverage up and buy real estate, the present situation is a boon.

    Try reading Kevin Erdmann for a while. He has great stuff on limiting access to credit markets by income class, and that process has gotten worse since 2007. The Great Recession storyline that poor people got access to credit and then busted is false. The price decline actually happened more in upper income housing. (In fact, there was an even bigger price decline in commercial real estate!)

    Presently, residential rents are actually outstripping inflation. Indeed, Erdmann finds there is little inflation outside of housing costs.

    There is a lot of foreign acquisition of apartment communities, as well.

    Property zoning and chronic large trade deficits result in both higher residential prices and rents.

    The real solution is wider access to credit markets and the elimination of property zoning.

    I repeat the question, why do America’s orthodox macroeconomists shriek into the megaphones whenever the topic is the minimum wage or “free trade,” but hit the mute button on property zoning, or the routine criminalization of push-cart or vehicle-vending?

    What makes property zoning an acceptable structural impediment?

    Why no screaming for free markets and highest and best use in property?

    And as for push-cart vending, forget it. Only little losers bring up that topic.

    Perhaps we should just levy a tariff on all imports, ala Richard Nixon. It would be a structural impediment. But no one cares about the structural impediment called property zoning, so why should we care about a structural impediment called an import tariff?

    What makes one structural impediment better or worse than another?

  19. Gravatar of Bill Ellis Bill Ellis
    4. January 2017 at 20:53

    Scott…18 comments on your passion… not bad. but nothing like a good trump bashing gets..

    But why not take on something that you can sink your economist teeth into and will generate lots of comments and traffic ? You can’t get more relevant or divisive then Healthcare reform…

    But then that is a battle that would expose the impossibility of the right’s “solutions” to match Obamacare…
    No reform coming from the right can work without some sorta socialism…That is Socialism as defined by the right…and confirmed by the supreme court….in a name…. Mandates.

    and I think you know this…and don’t want to admit it… and that’s why you won’t go there…

    It’d be interesting to know what you think Trumpcare should like…what kinda policy advice you’d offer… And heck, maybe people who came here to debate Trumpcare might Stumble upon NGDP Targeting too…

    but if you’d rather avoid the biggest econ blogosphere of the year… bummer for us all.

  20. Gravatar of Bill Ellis Bill Ellis
    4. January 2017 at 20:56

    biggest..”story”… of the year…l

  21. Gravatar of Bill Ellis Bill Ellis
    4. January 2017 at 21:01

    ” It would make more sense to shoot for below 2% inflation during booms, and above 2% inflation during recessions.”

    I think Keynes would approve…

  22. Gravatar of ssumner ssumner
    4. January 2017 at 21:22

    Bill. Another one of your moronic posts, which helps explain why I’ll never be a Democrat.

    I’ve posted on healthcare a number of times. I favor:

    1. Complete deregulation; insurance, employment, drugs, everything.
    2. No more tax subsidies for health insurance
    2. HSAs
    3. Government subsidies for catastrophic costs

    In effect, I would dramatically cut government spending on healthcare. Obviously Trumpcare won’t look like this.

    You’d know all that if you didn’t waste time writing such moronic posts, and read a bit more.

    Singapore’s government spends 1.2% of GDP on healthcare. How’s that working out?

  23. Gravatar of Ray Lopez Ray Lopez
    5. January 2017 at 06:43

    Sumner: “I’ve posted on healthcare a number of times. I favor:
    1. Complete deregulation; insurance, employment, drugs, everything.
    2. No more tax subsidies for health insurance
    2. HSAs
    3. Government subsidies for catastrophic costs”

    Oh, brave talk. But do you want to get down to brass tacks Mr. Theory? What are your views towards grey market imports? See: http://arstechnica.com/tech-policy/2010/12/supreme-court-lets-ban-on-gray-market-imports-stand/ Should the Ninth Circuit (California) be the only place where Costco v Omega applies? Or should the rest of the USA follow California law?

    What are you views towards differential pricing and patents? Should the first sale doctrine be applied to allow, as is now the law, the importation of grey market patented drugs into the USA from Canada, if it’s cheaper to make these drugs in Canada?

    Just to spell out the obvious, one reason health care is so cheap outside the USA is because the rest of the world (ROW) steals US medical tech and uses it for free. If the ROW paid their fair share costs would be lower in the USA as well. Don’t expect you to comment much, since your head is in the ivory tower clouds so much. Probably you’re anti-patent and wrongly think the board exams is restricting supply of doctors and driving up costs.

  24. Gravatar of Ray Lopez Ray Lopez
    5. January 2017 at 21:49

    OT–there’s no such thing as money illusion (the basis for Sumner’s NGDPLT, along with sticky prices). Proof? See the below. For the longest time people thought stocks following in the USA the “Fed Model” (the S&P earnings yield mimics the 10-yr bond yield) was the result of ‘money illusion’, but in fact the Capital Structure Substitution Theory showed the mimicking was due to deliberate company policy to appease investors.

    Once again, no such thing as “money illusion” hence money is neutral.

    https://en.wikipedia.org/wiki/Capital_structure_substitution_theory – Is the Fed model miss-specified? Thirty years of investor money illusion (left) or deliberate company policy (right)? from – https://en.wikipedia.org/wiki/Fed_model

  25. Gravatar of Carl Carl
    6. January 2017 at 09:51

    @Ray Lopez
    “Probably you’re anti-patent and wrongly think the board exams is restricting supply of doctors and driving up costs.”

    Do you think that the board exams is increasing the supply of doctors and driving down costs?

  26. Gravatar of anon/portly anon/portly
    6. January 2017 at 10:42

    This seems like one of the more subtle points that’s been made…. I am still scratching my head a bit.

    Suppose you have two parallel universes. In universe A, the Fed sticks with their 2% announced target but actually targets 2.5% (temporarily). In universe B the Fed raises the announced target to 3% but actually targets 2.5% (temporarily).

    Now suppose that the business cycle follows an identical path in both universes, both before and after the change to temporary 2.5% targeting. And in both universes the economy starts to falter.

    Maybe this already contradicts the point of the post, I’m not sure. But anyway, suppose now because the economy is faltering in universe A they quit targeting 2.5% and start targeting 2%, the announced target, instead. In universe B the lower the announced target from 3% to 2% and start targeting 2% instead of 2.5%.

    So far because I assumed ceteris paribus it has been equally easy to hit the 2.5% temporary target in both universes, i.e. they’ve done it with the same OMO’s.

    And again, maybe this thought example has already gone wrong, there must already – pre-slowdown – be some real differences in either the things the Feds had to do to make the business cycles the same or else differences in the things the Feds had to do make the rates of inflation the same. Or maybe if the business cycles were the same, the (path of the) rates of inflation and/or the OMO’s would have to be different, because of the difference in announced inflation targets.

    But again anyway, if everything really was the same up to the recognition of a slowdown, now it seems like the argument is that we are better off in Universe B. I am wondering if this is because in Universe B it will be easier to hit the new 2% (announced and actual) target, or because hitting the new target will be more effective (stimulative)?

    In writing all this out I’m a little less sure that this is an intelligent or intelligible question, but the point of the post seems to be about what happens at/after the next turning point (downturn), not before….

  27. Gravatar of Don Geddis Don Geddis
    6. January 2017 at 12:18

    @anon/portly: Your “universe B” requires an consciously malevolent central bank. You’re proposing that the Fed raises its explicit long-term, stable average inflation target to 3%, in a growing economy. It temporarily targets 2.5%. But then, just as a recession begins, rather than temporarily target at 3.5% (which would result in an average 3% rate, as they claimed they are targeting), they instead immediately change the target down to 2%. So they were lying about ever having a 3% target.

    Instead, what they’ve done is, on the eve a new recession, they’ve suddenly deliberately tightened money at the same time. So they will cause the “faltering” economy to instead crash into a depression.

    Yes, that’s possible. But why would anyone choose such a path? The point of committing to a 3% average target, is to actually experience >3% inflation during economic slowdowns. If you don’t do that, then you never actually had a 3% target in the first place.

    Then you’re asking a question about economic psychology, not just ordinary economics. Can the Fed temporarily fool the public into believing that the Fed will take some future action, which the Fed itself internally does not intend to actually take? This is the opposite of the usual RatEx assumption, which explicitly requires the Fed’s intentions, and the public’s beliefs about the Fed’s intentions, to be the same. You want to explore a possibility of deliberate misguidance. It’s not impossible, but it’s pretty complicated to figure out what happens if the Fed begins intentionally lying to the public.

  28. Gravatar of ssumner ssumner
    6. January 2017 at 15:54

    Ray, You said:

    Just to spell out the obvious, one reason health care is so cheap outside the USA is because the rest of the world (ROW) steals US medical tech and uses it for free.”

    If you are going to make idiotic statements, at least make them funny.

    Anon, Sorry, I didn’t follow that.

  29. Gravatar of Bill Ellis Bill Ellis
    6. January 2017 at 18:09

    Scott..I actually did recall that as you basic position… that Singapore system won’t work without mandate’s and neither would your HSA…

    I got you once before to admit that your program would need a mandate to work…

  30. Gravatar of Ray Lopez Ray Lopez
    10. January 2017 at 08:05

    @Sumner – sorry, I was not aware you are unfamiliar with the literature on medical technology being expensive in the USA because it is (rightly IMO) covered by patents, while outside the USA they are free-riders. As seen in a Washington Post article, quoting an authority on the matter. You need to read more professor instead of trolling your more ignorant readers (no, that’s NOT me). 🙂

  31. Gravatar of ssumner ssumner
    11. January 2017 at 13:29

    Bill, So what’s the point? If you knew that was my position, then why post a comment lying about my position? Do you just like to lie for the fun of it, like Trump?

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