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Central banking The Jackson four

Should the Fed adopt India s inflation target?

IN THE latter part of this week, monetary policymakers and theorists from

around the world were due to attend the Jackson Hole symposium, 6,800 feet up

in the mountains of Wyoming. Many people aggrieved savers and yield-hungry

investors probably wish they would never come back down. To their critics,

central bankers seem strangely committed to two unpardonable follies: eroding

the interest people earn on their savings and inflating the prices they pay at

the shops.

It was, therefore, brave of one central banker John Williams of the Federal

Reserve Bank of San Francisco to argue on August 15th that the Fed might need

to raise its 2% inflation target or replace it with an alternative if it is

successfully to fight the next downturn. Some economists favour an inflation

target of 4%. This is not as outlandish as it sounds. Indeed, the notion that

new circumstances require a new target may appear quite run-of-the-mill to

central bankers from the developing world who are taking part in the symposium.

Much criticism of the West s central bankers rests on the myth that they are

wholly responsible for rock-bottom rates. In fact, they seek the highest rates

the economy can bear, but no higher. When the economy is at full strength, they

want a neutral (or natural) rate that keeps inflation steady, neither

stimulating the economy nor slowing it. When the economy is overheating, they

want a rate above neutral. And when the economy is weak, they want one below

it. The neutral rate (r* in economists algebra) thus provides a vital

reference point for their policy. As such, it exercises considerable influence

over central bankers. But they, importantly, exercise precious little influence

over it.

According to economic theory, the neutral rate reconciles the eagerness to

invest and the willingness to save when the economy is in full bloom. As such,

it reflects the productivity of capital, the promise of technology and the

prudence of households, none of which are variables chosen by monetary

officials. The neutral rate cannot be observed directly. But Mr Williams and a

Fed colleague reckon it has fallen persistently: r-star (as he calls it) is

close to zero, or about two percentage points lower than it was in 2004.

If r-star is lower than it was back then, the Fed s policy rate must also be

lower to be equally stimulative. That means today s rate (of between 0.25% and

0.5%) is not as lax as it looks. Leo Krippner of the Reserve Bank of New

Zealand estimates that American monetary policy today is already as tight as it

was in July 2005, when the federal funds rate stood at 3.25%, having been

raised nine times.

The question preoccupying most Fed-watchers is how much tighter policy will get

in the next year or two. Mr Williams raises a different concern: how much

looser can policy get during the next downturn. If the Fed sticks to its

current inflation target of 2%, a policy rate of 0% would translate into a real

cost of borrowing of minus 2% (because the money debtors repay will be worth

less than the money they borrowed). That may not be low enough.

Such a rate would be only about two percentage points lower than Mr Williams s

estimate of the neutral rate. Raising the inflation target to 4%, say, would

allow real interest rates to drop about four percentage points below neutral if

necessary. (This is not the only reform idea. Another is targeting the

trajectory of nominal GDP, which reflects both economic growth and price

inflation; that might result in higher inflation when growth was weak and low

inflation when growth was strong.)

But even if a 4% target is desirable, would it be feasible? The Fed has

struggled to reach its current target quickly or consistently. What makes

anyone think it could hit a higher one? One answer is that a higher target

would free the central bank from a timidity trap , as Paul Krugman of the New

York Times calls it. In such a trap the central bank sets its goals too low,

and paradoxically falls short of them. A credible central bank might cut rates

to zero and promise 2% inflation. If it is believed, inflation expectations

will rise and the anticipated real cost of borrowing will fall to minus 2%. But

if the economy actually needs a real rate of minus 4% to revive, spending will

remain too weak, economic slack will persist and inflation will ebb, falling

under target. Conversely, if the central bank promises 4% inflation, its

pledges will be both believed and fulfilled.

Shooting r-star

Western policymakers dislike tinkering with their inflation targets. But in the

wider universe of central banks, periodic revisions are no big deal. Indonesia

sets its targets for a three-year period, as does the Philippines, Turkey and

South Korea. This flexibility need not destroy a central bank s sound-money

credentials: South Korea s inflation is even lower than America s.

Although a target centred on 4% sounds scandalous to rich-world central

bankers, it is not unusual elsewhere. Indonesia pursues one. Brazil s inflation

target is 4.5%. India is lowering its target from 6% last year to about 4% for

the future. The committee recommending that figure was chaired by Urjit Patel,

who will be the Reserve Bank of India s next governor (see article).

One advantage many emerging economies enjoy over richer ones is a higher

r-star, thanks to faster rates of underlying growth and inflation, as low local

prices converge towards higher international prices. That gives their central

banks more room to cut interest rates in the face of a downturn. Indeed, it is

hard to think of any catch-up economy that has remained stuck at zero rates.

If Mr Patel succeeds in his new job and the Fed embraces reform, America s

inflation target may one day resemble India s. But India will still worry more

about overshooting its target than undershooting it, and America will still

probably harbour the opposite set of concerns. Their inflation targets may

match, but their r-stars will not be aligned.