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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.