In general, there are four characteristics that a good set of price level targets should have:
- It should be realistic. We might love to see a 3 percent inflation rate for 2009, but that’s not going to happen, no matter what the Fed does. To be credible, the targets must allow for a couple of years of low inflation, simply because we know that the Fed has little influence over the inflation rate in the short run. In general, the targets should be reasonably conservative relative to what might be possible, because, if the early targets are not hit, the Fed will have more difficulty hitting the later targets. We don’t want to set the Fed an impossible task in the case where things go badly at first.
- It should target prices high enough to make people nervous, even if they don’t think the Fed can hit those targets. This is where my poker game analogy (as discussed in the previous post) comes in. You may think that the player with the four hearts up is probably bluffing, but if she throws enough blue chips into the pot, and if you’re a conservative player, you’re going to fold your three aces anyway. These days almost everyone is a conservative player. So if the Fed sets the price level target high enough, just the risk that it might hit that target should be enough to motivate investors to hold nonmonetary assets. The choice today is between risky assets with a high expected return (stocks, high-yield bonds, etc.) and safe assets with a low expected return (cash, Treasuries, etc.). Set a price level target high enough, and the choice – even if you don’t have much confidence in the Fed’s ability to hit its targets – will be between two risky assets, one with a high expected return and the other with a low expected return.
- It should transition to a “normal” rate of inflation in the long run. A normal rate of inflation used to be 2 percent, but recent experience shows that 2 percent is dangerously close to zero. I think 3 percent is the lowest reasonable target for a long-run inflation rate, and that’s what I will assume in my example, because it’s close to what most people would think of as normal. If it were up to me, I would choose a long-run inflation target of 4 or 5 percent. (I’m using the phrase “inflation target” loosely. I mean the inflation rate implied by long-horizon price-level targets.) It’s an open question how long exactly the long run is. In my example, I’m choosing a set of targets that implies a 3 percent inflation rate starting in year 14 (2022, since 2009 is year 1). Note that the 3 percent implication is conditional on earlier targets being met. If the Fed falls short of the price target for the end of 2021, the inflation rate will have to remain higher than 3 percent for a while thereafter in order to catch up.
- It should target prices low enough that they don’t imply ridiculously high inflation rates. After a while it should be technically feasible for the Fed to engineer an inflation rate as high as, say, 20 percent, and if that were expected to happen, it would certainly discourage people from holding monetary assets. But at some point the cure becomes worse than the disease. If we’re targeting a long-run implied inflation rate of 3 percent, the transition from 20 percent to 3 percent would likely be very unpleasant. And at some point also, it becomes too unfair to ask today’s long-horizon creditors and fixed income recipients to bear such a large part of the burden for fixing the economy. The targets in my example imply a maximum annual inflation rate of 10 percent (conditional on earlier targets being met), a maximum (conditional) 5-year average inflation rate of 8.4 percent, and a maximum (conditional) 10-year average inflation rate of 6.7 percent. I would say that those are high (as point 2 requires) but not ridiculously high. (Others may have a different opinion.)
| A | B | C | D | E | F | G |
| price | implied | implied | implied | implied | implied | |
| target | annual | average | inflation | inflation | average | |
| core | inflation | inflation | target | target | inflation | |
| CPI) | target | target | over | over | target | |
| from | prior | prior | from | |||
| year zero | 5 years | 10 years | year 5 | |||
| assuming | ||||||
| 2008 | 216.1 | zero | ||||
| 2009 | 219.3 | 1.5% | 1.5% | inflation | ||
| 2010 | 223.7 | 2.0% | 1.7% | from | ||
| 2011 | 230.4 | 3.0% | 2.2% | year 0 | ||
| 2012 | 239.7 | 4.0% | 2.6% | to year 5 | ||
| 2013 | 254.0 | 6.0% | 3.3% | 3.3% | ||
| 2014 | 274.4 | 8.0% | 4.1% | 4.6% | 27.0% | |
| 2015 | 301.8 | 10.0% | 4.9% | 6.2% | 18.2% | |
| 2016 | 329.0 | 9.0% | 5.4% | 7.4% | 15.0% | |
| 2017 | 355.3 | 8.0% | 5.7% | 8.2% | 13.2% | |
| 2018 | 380.1 | 7.0% | 5.8% | 8.4% | 5.8% | 12.0% |
| 2019 | 403.0 | 6.0% | 5.8% | 8.0% | 6.3% | 10.9% |
| 2020 | 423.1 | 5.0% | 5.8% | 7.0% | 6.6% | 10.1% |
| 2021 | 440.0 | 4.0% | 5.6% | 6.0% | 6.7% | 9.3% |
| 2022 | 453.2 | 3.0% | 5.4% | 5.0% | 6.6% | 8.6% |
| 2023 | 466.8 | 3.0% | 5.3% | 4.2% | 6.3% | 8.0% |
| 2024 | 480.8 | 3.0% | 5.1% | 3.6% | 5.8% | 7.5% |
| 2025 | 495.3 | 3.0% | 5.0% | 3.2% | 5.1% | 7.2% |
| 2026 | 510.1 | 3.0% | 4.9% | 3.0% | 4.5% | 6.8% |
| 2027 | 525.4 | 3.0% | 4.8% | 3.0% | 4.0% | 6.6% |
| 2028 | 541.2 | 3.0% | 4.7% | 3.0% | 3.6% | 6.3% |
These targets imply a 5.8 percent average annual (compound) inflation rate over the next 10 years. (See the entry for December 2018 in column D.) Suppose the Fed were also to target the 10-year Treasury yield at zero (a target the Fed could certainly achieve by intervening directly in the longer term Treasury market, although meeting that target could conceivably require the Fed to buy up almost all of the national debt). The result, if the Fed were to hit its price level targets, would be a real (inflation adjusted) 10-year Treasury return of -5.8 percent.
Markets would not have full confidence in the Fed’s ability to hit its price targets, but the threat of a -5.8 percent real return, even with only limited credibility, should be enough to make people nervous. And the more nervous people get about holding monetary assets (in which term I mean to include Treasury notes), the more they will invest in real assets (or just spend money), and the easier it will be for the Fed to hit its target. It might not be necessary to set the target real return as low as -5.8 percent (i.e. to target the 10-year Treasury yield at zero), but the price level targets would give the Fed room to maneuver.
To get an idea of how the “catch up” process would work with these targets, consider the case where the average inflation rate over the first 5 years is zero. In December 2013, the Fed will miss the target by a factor of 0.85 (the actual core CPI of 216.1 divided by the target of 254.0). The Fed will then have to make to make up that 15 percent “deficit” over the subsequent years by pushing the inflation rate above the original “planned for” inflation rates. Column G shows the average annual inflation rates that would be necessary to make up the deficit in a given number of years. To make it up in one year (obviously unrealistic) would require an inflation rate of 27 percent. To make it up in five years (fairly realistic) would require an inflation rate of 12 percent.
To get an idea of the overall pattern of inflation rates implied by this set of targets, we can divide the next 20 years into 5-year intervals and look at what the average inflation rate would be in each of those intervals if all targets are hit:
- Dec-2008 to Dec2013 3.3%
- Dec-2003 to Dec2018 8.4%
- Dec-2018 to Dec2023 4.2%
- Dec-2023 to Dec2028 3.0%
The hope is that the transition from high to normal inflation (after 2015) will not be too difficult, because it will be fully anticipated. Individual businesses will expect a slowdown in the overall inflation rate and will therefore slow down their own price and wage growth, allowing the anticipated monetary policy to support a normal level of output and employment. That’s the theory, anyhow.
DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.
12 comments:
Here's an example: FDR tried keeping prices high and it smashed the economy for another 6-10 years.
Norman,
It's true that FDR did try keeping prices high, but that was in the early part of the recovery, long before the second dip of the Depression, which began in his second term. The NIRA (FDR's main attempt to keep prices high) was declared unconstitutional by the Supreme Court before it had a chance to smash the economy. At worst, it weakened the recovery that happened during FDR's first term.
As he entered his second term, he decided that prices had risen enough, and he tightened his fiscal policy (even as the Fed tightened monetary policy), whereupon prices fell again, and the economy got "smashed." It's pretty clear that the periods of economic contraction during the 1930's were associated with deflation, not inflation.
In any case, there is a fundamental difference between FDR's attempts to keep prices high and what I am suggesting. FDR tried to keep prices high by creating government-sponsored cartels. Most economists believe that the formation of cartels tends to weaken the economy, because it reduces aggregate supply. (There is room for disagreement, though, about the effects of aggregate supply shifts in a potentially deflationary environment.)
What I am suggesting here is to announce the intention of monetary policy to "pull" prices up from the demand side, rather than "pushing" them up from the supply side. The process of pulling prices up also tends to pull output up in the short run, so it strengthens the economy, rather than weakening it. (It's true that part of the immediate impact of announcing price targets would probably be to reduce aggregate supply in nominal terms, but by enabling the Fed to set negative real interest rates, the announcement would almost certainly increase aggregate demand more than it reduces aggregate supply.)
Andy,
I think I can see the problem with what you inflationists propose. BTW, I'm very long gold after years of being very short credit-related stocks. So I want very much for you to be listened to. At the same time, I think your argument is dangerously flawed.
First there's the historical evidence. We have the 1937 U.S. recession, from which we could conclude that the 1934-1936 monetary (and it was, essentially, monetary) stimulus was ineffective because its removal was anything but "smooth". There are many other examples of austerity being forced on governments that undertook monetary stimulus, but I've commented on them before, so enough of that.
Beyond analogies, a thought experiment might be useful. Imagine that in a credit boom investors create stable expected returns from lower and lower return projects. How? By levering themselves ever higher. The result is that those low-return projects cannot service debt, and the credit boom turns to bust.
Now, what would be necessary for investors to turn bust to boom again? Essentially, very high, unlevered, real returns on assets. It would be necessary to present new investors with extremely high risk premia to make up for uncertainty. Once those risk premia are available, the bust is over, and growth begins.
The problem with your inflation proposal is that it attempts to deny new investors high returns. It does so by artificially propping up asset prices. This, and the uncertainty over a "smooth" removal of inflation, kills private investment in almost every high-inflation country you can find. Chronic low growth is no solution to a debt crisis; just the opposite.
David,
I read the 1937 evidence as being strongly in favor of my proposal. Between 1933 and 1937, the price level rose by only 9.2%, or an annual rate of 2.2%. If the Fed had based its policy on targets even remotely like the ones I suggest, it would have accelerated rather than decelerated in 1937. The problem was the too-early removal of the stimulus, not a lack of smoothness in the economy's response. In fact, the removal of the stimulus was rather abrupt. (Fiscal policy went from a large deficit to a surplus within a year, and the Fed abruptly increased the reserve requirement.) If the stimulus had been removed more smoothly, the economy's response would likely have been smoother.
In fact, when the government finally did (unintentionally) institute a policy resembling the one I advocate, the transition to normal growth was surprisingly smooth.
As to your other argument
The problem with your inflation proposal is that it attempts to deny new investors high returns. It does so by artificially propping up asset prices. This, and the uncertainty over a "smooth" removal of inflation, kills private investment in almost every high-inflation country you can find.
The reason that inflation killed private investment in other cases is that investors had alternatives: they could invest in other countries and get decent returns with only moderate risk. That's not likely to be true in this case, because other countries will have an incentive to follow the Fed's lead (so as to avoid killing their export markets). The reality is that a huge economy like the US (or, to a lesser extent, Japan, China, or the Euro Zone) operates under completely different rules than a small or medium-sized economy.
I should also point out that we're not necessarily actually denying new investors high returns: we're only threatening to deny them high returns. If they go ahead and invest in real assets, then the economy will recover, and they will get high returns. I may do another blog post about how, in this scenario, the Fed is like a "godfather" enforcing a cooperative solution in a prisoner's dilemma game.
Andy,
Returns are a function of the asset price and real growth. Inflation affects both in unfavorable directions. The evidence of chronically low private investment in high inflation countries is incontrovertible. You dismiss it by claiming there's an exemption for "big" countries. Where's the evidence? Where is the different path in causal chain? Certainly from the perspective of out-sized current account deficits, chronically low savings, and record high (350%) credit to GDP, as William Buiter recently wrote, we resemble a banana republic much more than the repository of the global reserve currency.
You seem to argue that, since they can't flee into the reserve currency (from the reserve currency), investors have to settle for lower returns. Not at all. Required investment returns are a function of temporal preferences for spending, not of the range of alternatives available. In inflationary countries, that function is heavily skewed to the present. Savings flee to foreign countries not to earn returns but to preserve value (pre-hedge funds, rich Latins used to settle for 1% in Swiss accounts). In the case where no currency offers the prospect of value preservation, investors can hoard consumable commodities or simply buy precious metals. Today this behavior would seem anachronistic, yet the reason its been absent in the post-War period is because the alternative currencies existed. Now they don't, so why not expect a return to previously-popular stores of value? This is velocity, just as capital flight to dollars is velocity. You think the Fed can keep velocity under control, but the evidence of 1979-1980 says otherwise, and that was without a very high economy-wide debt ratio.
I enjoy this debate, and its important one. I just would prefer that inflation proponents make their arguments flow backwards in time. Start out by fleshing out, completely, what the future costs of removal might be, and then work back to how you enter it.
By the way, ex-post observations that stimulus removal was "too early" are dubious. We removed stimulus at a snail's pace starting in 2005, and now we face a deep recession. Did the 2005 Fed make the same mistake as the 1936 Fed? If true, you should be calling for Bernanke's resignation, because if anyone should have had perfect timing on this, it should have been him. Except--you now expect him to have perfect timing in the future. How can that be?
David,
The evidence of chronically low private investment in high inflation countries is incontrovertible. You dismiss it by claiming there's an exemption for "big" countries. Where's the evidence? Where is the different path in causal chain?
The US was a high inflation country during the late 1970's, and private investment was higher than usual as a fraction of GDP -- so clearly there is an exception to that incontrovertible evidence.
Big countries (especially the biggest one, which accounts for about 25% of world GDP) are different because the rest of the world depends on them -- somewhat like the way in which big banks are different. The US in particular is different because so many countries depend on the US for their export demand. If the dollar were to collapse, it would be a bigger disaster for the rest of the world than for the US (and it would be worst for those countries that did the least to resist it -- i.e., the ones that would end up with overvalued currencies).
Investors can hoard consumable commodities or simply buy precious metals. Today this behavior would seem anachronistic, yet the reason its been absent in the post-War period is because the alternative currencies existed. Now they don't, so why not expect a return to previously-popular stores of value?
Gold only works as a store of value if it is widely accepted as a world currency the way it was before WWII. Otherwise its value is at the mercy of speculators. It is actually a very risky asset, more risky than capital assets and without the intrinsic return that such assets have. The same is generally true of other commodities.
You think the Fed can keep velocity under control, but the evidence of 1979-1980 says otherwise
Again, I think the evidence supports my case. During the period from 1980 to 1983, the Fed was quite successful at reducing the inflation rate. Granted, it wasn't a pleasant experience, but compared to the prospect of a deflationary spiral, it doesn't look so bad in retrospect.
The 1980-1983 experience was difficult in part because the Fed lacked credibility. It had repeatedly allowed the inflation rate to increase while decrying the high rates of inflation. Moreover, by concerning itself with the inflation rate rather than prices, the Fed was in effect forgiving itself for each mistake as soon as the consequences became clear. With price level targets, the Fed will not have the luxury of automatically forgiving itself, and it should have a great deal more credibility. The very fact that prices rise above the target would lead business to expect tighter money and thereby deter them from raising prices -- just the opposite of the situation that prevailed in the 1970's.
My argument flows backward in time from 1980-1983 as a worst-case scenario that isn't really so bad.
We removed stimulus at a snail's pace starting in 2005, and now we face a deep recession. Did the 2005 Fed make the same mistake as the 1936 Fed?
The 2005-2007 experience is again evidence for my case: the problem was that the Fed's inflation target was too low. The Fed did make, on a smaller scale and in a very different context, essentially the same mistake as the 1936 Fed, but it would be foolish to attribute this mistake specifically to Chairman Bernanke, because there was a consensus (in which I did not participate) that the inflation rate should be near 2%. When the core rate threatened to go significantly above 2%, the Fed removed the stimulus -- and then dragged its feet about applying a new stimulus when the economy weakened. The situation we now face would not be a problem if the inflation rate had started out at 4%. Now it would be down to maybe 3%, an the Fed would simply keep interest rates down until the economy recovered.
Andy,
Your "big country" argument works if foreign central banks are the primary sources for our deficit financing. These institutions can think about the "national interest" when making investment decisions. Private investors, on the other hand, are mostly profit-maximizing and will not consider the effect of their collective action on their well being. If this were the case, investors would not have sold stocks and send the S&P down 50%.
Even if China invests all available reserve growth in Treasuries, that will probably amount to about 20% of this year's deficit. The figure in previous years was on the order of 75%-100%. Our incremental borrowing must come from private investors, and they simply don't care whether we are a "big" country or a reserve currency.
I'm surprised that private investment to GDP was high in the 70's. We might as well throw supply-side economics out the window! If that's the way to juice investment, then why not always run with an over-5% inflation rate? If inflation does not affect investment, then I'm missing the downside of it. In every other country, that downside is depressed investment levels. Inflation is certainly not negative for inventory, consumption, or public spending -- the other components of GDP.
True, the 1983 recession will likely pale compared to the current one. I would argue, though, that debt to gdp levels going into the recession were quite low, and that there was no economy-wide debt crisis in the 70's. Even so, by 1987 the cost of servicing the debt caused a scare over projected deficit growth. Imagine what that relatively benign scare would have been like if our debt to gdp had started at 350% and the government had been nationalizing it in the Carter years, as it is doing today. The essence of a sovereign debt spiral is that, the more the interest cost rises, the higher debt goes, the more the interest cost rises. This dynamic will be much more powerful during the next Volker-like austerity plan than it was in the late 80's.
Thanks for all your thoughtful responses, which are challenging to consider and counter.
Continuing the discussion,
Our incremental borrowing must come from private investors, and they simply don't care whether we are a "big" country or a reserve currency.
In the short run it won't come from private investors; it will come from the Fed, since the Fed will buy as many T-bills as it takes to keep the federal funds rate below 0.25%. Based on the Japanese experience, I have a feeling the short run will turn into the long run. (In principle, the Fed always has the option of raising the reserve requirement to avoid the need to contract the base money supply. As long as the banking sector remains in trouble, the Fed will avoid raising reserve requirements, since that would further stress the sector. But when and if it becomes necessary to rein in the money supply, the banking sector will have recovered and can afford a higher reserve requirement.)
by 1987 the cost of servicing the debt caused a scare over projected deficit growth
As I see it, the government had been trying to weaken the dollar and just overshot its mark. Surely the debt service problem could have been foreseen 3 years earlier, and indeed it would have appeared worse, because interest rates were higher. Yet in 1984 demand for dollar-denominated securities was extremely high. The difference is the easy money policy that prevailed after 1985.
Imagine what that relatively benign scare would have been like if our debt to gdp had started at 350% and the government had been nationalizing it in the Carter years, as it is doing today.
It seems to me that nationalization of private debt, to the extent that it is done without the intention of a subsidy, should be good for US fiscal health in the long run. As long as the debt remains tenuous, the environment will remain deflationary, and the Fed can monetize the debt. Once the deflation risk has passed, the debt should return more than the government's cost of funds, so it's a net win for the government. Essentially, the government, unlike the private sector, can use leverage without taking much risk, because it can backstop itself. As long as its bets fail to pay off, the government can refinance them on its own without adverse consequences.
The essence of a sovereign debt spiral is that, the more the interest cost rises, the higher debt goes, the more the interest cost rises. This dynamic will be much more powerful during the next Volker-like austerity plan than it was in the late 80's.
If the debt is merely refinancing past borrowing and not supporting new spending, then the rising interest rates will weaken the economy more effectively and won't have to rise as far to bring down inflation. As long as the fiscal stimulus eventually ends, and as long as entitlement programs are brought under control, this should be the case. (Of course the latter issue -- at least in the case of Medicare -- is a huge wild card that potentially dwarfs everything we are talking about here. If you assume that Medicare as currently mandated will be financed indefinitely out of general revenues, then we have been bankrupt for years.)
Andy,
Your view is that the Fed can step in to monetize the deficit (and a portion of existing debt) without any impact on expectations. Now, imagine that this is the "consensus" view held by policy makers and Fed officials. What is the long-term path of monetary policy under such a view? The business cycle becomes more and more asymmetrical: booms met with careful hand-holding in an effort to avoid the "premature removal" charge, recessions plumbing ever-deeper commitments of the Fed's balance sheet. We've been in this cycle since 2001 (one might argue 1998). But you're expecting market participants to take an entirely benign view of this almost decade-long experience.
Monetization is incompatible with reserve currency status. At the crux of our disagreement are "animal spirits". I'm a market participant, and we've seen wild, non-linear gyrations in these spirits over the past ten years. Another name for these spirits in the monetary realm is the under-appreciated term "velocity". You, and presumably the Fed Chairman, believe velocity is a relatively stable residual of the aggregate demand equation. Not so. It will be the driving factor going forward, and I would argue neither of us has a crystal ball in predicting it. The difference is I'm not coming up with policy mandates that depend on those predictions; rather, I'm coming up with investment postures that protect me from that prediction being wrong,
BTW, I understand the the essence of your plan is to impact velocity. Its just that you tend to see the impact as returning velocity back into its inherently "stable" orbit. I see this differently: the stability comes not from some physical law but from the promise of sacrifice made by the polity of a reserve currency country: "You let us borrow in dollars, we promise, when the time comes to choose austerity over growth."
Your view is that the Fed can step in to monetize the deficit (and a portion of existing debt) without any impact on expectations
Not at all. The whole point of the policy I suggest is to create expectations of inflation, and part of the mechanism would be monetization of debt. But the Fed has done a lot of that already and hasn't managed to engender those expectations. Once that policy succeeds, fiscal policy can be tightened again, and it will not be necessary to monetize large amounts of additional debt. But the Bank of Japan (if I'm reading the statistics right) did undertake monetization on an even larger scale than what anyone is contemplating for the US, and it still did not create expectations of inflation.
booms met with careful hand-holding in an effort to avoid the "premature removal" charge
A higher long-term inflation target is all that is necessary to avoid the premature removal issue -- that is, to avoid the potentially disastrous consequences of removing a stimulus too soon. It's not hand-holding; it's just creating a cushion to be available in case of a recession. Under those circumstances, a recession would not involve large-scale monetization, just temporarily lower interest rates, which would involve a modest degree of monetization (as in most postwar recessions). With such a cushion available, the Fed can afford to risk removing a stimulus too soon, because it can easily undo the consequences of such a mistake.
Your view of "velocity" or "animal spirits" seems to be that a high-debt economy is always tending toward extremes of high and low. I will acknowledge that higher debt levels make the economy comparatively less stable, but I think policymakers can still approximate a happy medium, provided they have enough leeway in both directions to handle deviations from that medium.
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