The New Inflationists

Yellen, inflation, Fed, zero lower bound, inequality, wage growth
The Chimera of Arezzo, c. 400 BC, found in Arezzo, an ancient Etruscan and Roman city in Tuscany, Museo Archeologico Nazionale, Florence. https://commons.wikimedia.org/wiki/File:The_Chimera_of_Arezzo,_c._400_BC,_found_in_Arezzo,_an_ancient_Etruscan_and_Roman_city_in_Tuscany,_Museo_Archeologico_Nazionale,_Florence_(22622758172).jpg. by Carole Raddato CC BY-SA 2.0
Image: Carole Raddato/Wikimedia

“Fed Up” is the name of a progressive initiative that describes itself as a coalition of “community-based organizations, labor unions, policy experts, and faith leaders…united in our call for a strong economy that works for everybody and a more transparent and democratic Federal Reserve." Its main organizer is the Center for Popular Democracy, with support from the AFL-CIO, and the Economic Policy Institute, among others.

Fed Up has two main causes. First, it raises an important issue when it questions the current governance structure of the regional Federal Reserve Banks. Ironically, while it calls for greater diversity of backgrounds among FRB directors, Fed Up never seems to notice that FRB presidents are today the main source of diversity of thinking on the Federal Open Market Committee. Between 1995 and 2013, Dan Thornton and David Wheelock have found, “there were just two dissents by governors compared with 67 by presidents.” Since 2006 there have been zero dissents by members of the Board of Governors.

Fed Up secondly offers advice to the Federal Open Market Committee, the monetary policy body whose voting members consist of the Board of Governors plus a rotating subset of Reserve Bank presidents. It urges the FOMC to pursue a secularly more expansionary monetary policy, in the erroneous hope that this would bring greater prosperity to workers. In its wishful view “The Fed should target real wage growth that is higher than economy-wide productivity growth, in order to combat inequality and boost workers’ share of income.”

To say that “the Fed should” do x is to imply that the Fed can do x. Regrettably, however, the Fed has no policy tool with which to target real wage growth. Nor does any agency have a tool to raise real wage growth above productivity growth. The Fed can print money faster, which generates higher inflation, but this does not sustainably increase real wages or employment. The Fed cannot improve the productivity or demand for labor by generating 4% or 5% rather than 2% inflation in the long run. (Raising inflation even further to double digits would clearly harm workers by deranging economic coordination).

Nor does faster money growth sustainably lower the real interest rate. It is an elementary proposition of monetary theory that the real interest rate is independent of monetary policy in the long run. Faster money growth only raises inflation and thereby the nominal interest rate, which is determined by the real interest rate plus the expected inflation rate. For the Fed to secure lower nominal interest rates in the long run it must lower the inflation rate, and so must pursue a less expansionary monetary policy.

In June, Fed Up organized and published a letter calling on the Fed to commit explicitly to higher inflation by raising its official inflation target above the current 2% rate. Twenty-two professional economists signed the letter, including Nobel laureate Joseph Stiglitz; former Minneapolis Fed President Narayana Kocherlakota; and several former Obama administration economists. Prominent academic signers included Justin Wolfers, Laurence Ball, and Brad DeLong. The letter can be read in its entirety here.

The letter’s argument does not turn on the above-mentioned confusions between nominal and real variables, or confusions between short-run and long-run effects of monetary policy. On the contrary, it implicitly rejects them. Its argument is more sophisticated: two percentage points in higher secular inflation, by raising the secular nominal interest rate two percentage points farther above its zero lower bound, would allow the Federal Reserve temporarily to reduce the real interest rate (the nominal rate minus the given inflation rate) by two more percentage points when it lowers the nominal rate to zero in a recession. The Fed would thereby be able to deliver more stimulus.

Kocherlakota spelled out the logic in a blog post:

The inflation target helps define how much stimulus the Fed can deliver when it lowers interest rates to zero (a boundary below which the central bank has been unwilling to go). In a higher-inflation environment, a nominal fed funds rate of zero results in a lower real, net-of-anticipated-inflation rate — the rate that economists typically see as most relevant for consumer and business decisions. If, for example, people expect inflation to be 3 percent, then a zero nominal rate translates into a negative 3 percent real rate — a full percentage point lower than the Fed could achieve if expected inflation were 2 percent. Experience suggests that the Fed could use the added ammunition.

Or as David Beckworth and Ramesh Ponuru boiled down the argument: “During a recession, central banks usually cut interest rates in order to stimulate the economy. The higher the interest rate is at the start of the recession, the more they can cut it.”

Kocherlakota conceded that “there's also a case against raising the inflation target,” although he didn’t spell it out. He concluded: “That’s why the more important part of the letter is its call for ‘a diverse and representative commission’ to re-examine the monetary policy framework.”

The argument has been around for years that a 4% or 5% inflation target would be better than a 2% or 0% target. Its lineage goes back at least to a 1996 paper by Akerlof, Dickens, and Perry, which emphasized wage stickiness rather than the zero lower bound. (George Akerlof, by the way, is the husband of Fed Chair Janet Yellen.) More recently Olivier Blanchard in 2010, while IMF Chief Economist, suggested with co-authors that central banks should consider raising their inflation targets and thus nominal interest rates to create more space above the zero lower bound (hereafter ZLB). Laurence M. Ball, a co-signer of the Fed Up letter, argued explicitly for raising the inflation target to 4% in a 2014 IMF working paper emphasizing the ZLB.

The Fed Up letter argues that the ZLB has become a more frequent constraint on policy in light of a secular fall in the equilibrium real interest rate toward zero, citing an argument to this effect by San Francisco FRB president John Williams. In the words of the letter, although a 2% inflation target “seemed to give ample leverage with which the Fed could lower real interest rates” once upon a time, zero rates for seven years after the financial crisis failed at “sparking any large acceleration of aggregate demand growth.”

The most straightforward objection to raising the inflation target is that a higher secular inflation rate raises the well-known costs of inflation. It means a higher and more distortive tax on money-holding, reducing consumer welfare. It means greater “menu costs” of more frequently changing nominal prices. Higher inflation rates are associated with higher variability in relative prices, increasing noise in the price system. But these costs alone are not enough to counter the claim that the welfare costs of a more frequently binding ZLB are even greater. (The letter simply dismisses the costs of increasing the inflation rate by few percentage points, asserting a “lack of evidence that moderately higher inflation would harm Americans’ standard of living.”)

An effective challenge to the proposal for a higher inflation target requires a challenge to the underlying claim that the ZLB prevents an effective anti-recession monetary policy. The underlying claim rests on the New Keynesian or Taylor Rule conception that monetary policy is recession-fighting if and only if it lowers the nominal interest rate. But this is a mistake. The problem of recession, to the extent that monetary policy can relieve it, is an unsatisfied excess demand to hold money (the quantity demanded exceeds the quantity supplied at the current price level and nominal interest rate). Sales and employment are depressed because an excess demand for money corresponds to an excess supply of goods and services in general: consumers don’t buy when they are trying to build up their money balances. Monetary policy can in principle remedy the problem by expanding the quantity of money in the right amount at the right time.

But wait, you might say, didn’t quantitative easing fail to improve anything in the last recession? No. In the relevant sense – increasing the quantity of money in the hands of the public – quantitative easing wasn’t even tried. As I have emphasized in a previous article, in the face of a large 2009 increase in the holding of M2 balances relative to income (a large drop in the velocity of M2), the Fed did not raise the path of M2 growth. Its QE programs did raise the path of M0, the monetary base, but the Fed prevented that M0 growth from fueling faster M2 growth by paying banks to sequester the additional M0 (it paid them interest on excess reserves for the first time).

Absent offsetting higher interest on excess reserves, quantitative easing is capable in principle of providing all the monetary “looseness” needed. The ZLB is no obstacle to expanding M2. Consequently a higher secular inflation rate brings with it higher costs, but no offsetting benefit of enlarging the power of monetary policy to do the needful in a recession.

Finally, it should be noted that Chair Yellen, after having rejected the idea of raising the Fed’s inflation target on many previous occasions as a threat to the credibility of the FOMC, responded more positively to the idea after the Fed Up letter. At her June 14 press conference, she echoed the letter’s argument:

[A]ssessments of the level of the neutral likely level currently and going forward of the neutral Federal funds rate have changed, and are quite a bit lower than they stood in 2012 or earlier years. That means that the economy is, has the potential where policy could be constrained by the zero lower bound more frequently than at the time that we adopted our 2% objective. So it's that recognition that causes people to think we might be better off with a higher inflation objective. That is an important set, this is one of our most critical decisions and one we are attentive to evidence and outside thinking. It's one that we will be reconsidering at some future time. And it's important for our decisions to be informed by a wide range of views and research, which is ongoing inside and outside the Fed.

The day after Yellen’s press conference, as the below chart shows, a leading market measure of the expected inflation rate stopped falling. It has since risen, and is now 12 basis points higher.

  • Carolina Alves

    Why is this statement there "George Akerlof, by the way, is the husband of Fed Chair Janet Yellen"?

    • Ray Lopez

      Good point, but only if you're in California. In California, publication of private facts of a public person, even if true, is actionable as an invasion of privacy. In most other states you also have to be a private person (not a public person, which George Akerlof is)

      • Carolina Alves

        My point lies somewhere else, but thanks I didn't know about this.

        • Joesph Constable

          Are you defending Janet Yellen because she is a woman?

          • Carolina Alves

            No, of course not. My comment does not mean or imply any defense. Not sure how you came to this interpretation.

    • Lawrence White

      It's an aside (hence "by the way" and parentheses). Having just cited Akerlof as an important inflationist, I thought it might be of possible interest to people who didn't know. Nothing else I say rests on it.

      • Carolina Alves

        Thanks for the replay. Okay, I knew it was an aside. I wondered because I didn’t understand why disclosing that Akerlof is her husband was of any relevance for the main argument of the piece. Why is the ‘husband relationship’ of any interest in a piece on inflation/Fed/monetary policy? It is not like if people reading this are reading a gossip magazine. I don't doubt your statement that nothing else rests on it, but the economics field/profession is still permeated by sexism and we should be very careful about not reproducing it — even unintentionally.

  • Jerry O'Driscoll

    I have two main comments on this excellent post.

    First, the Fed has brought this on itself. By its continual emphasis on employment and the unemployment rate in setting policy, it suggests that it can control real variables. When pressed, Bernanke used to admit the Fed cannot affect these variables in the long run. We are eight years into recovery. When does the long run come?

    Second, I want to extend Larry White's query about what can the Fed do. Can a central bank produce a steady high rate of inflation? Decades ago, Mike Bordo answered the question. As inflation rates become higher, they also become more variable. (He thereby confirmed a hypothesis first advanced by Hayek.)

    In the last few years, former Cleveland Fed president Jerry Jordan has argued the Fed hqas lost control over inflation. That would add an additional problem of control.

    • Hu McCulloch

      Jerry —
      Where did Jerry Jordan's argument appear? I'd agree that Interest on Excess Reserves (IOER) has rendered the Fed rudderless, but would be curious to see if his take is similar to mine.

    • Lawrence White

      As a long-time inflation "dove" and emphasizer of the Fed's employment mandate, Yellen may enjoy having public pressure from the inflation-dove side.

  • Ray Lopez

    Outstanding article by the author. Money is indeed neutral not just long term (even monetarists agree) but short term too IMO. However, in defense of the "letter" arguing for raising interest rates now so you can cut them for stimulus later, it could be argued that 'money illusion' works best in deflation rather than inflation, that is, during busts rather than booms. That would be the only tenable argument I could see for raising interest rates now.

  • Milton_Hayek

    The money cranks at the Fed will be the death of us…

  • Kevin Dowd

    Nice posting Larry.

    Milton Friedman taught us that a central bank cannot control ‘real’ variables, only nominal ones.

    As inflation increase, I would suggest that the costs of inflation (not just higher menu costs, but higher costs from greater uncertainty, more distortions etc.) must also increase, but any ‘benefits’ – to the extent that there are any are – will not be lasting. Therefore, it would be wise to keep the inflation target (if there is to be one) low.

    Now soft money advocates will argue that falling real rates of interest reduce central banks’ room for manoeuvre – the lower the real rate, the lower the nominal rate, other things equal, and the less room left in which to reduce the latter before it hits the Zero Lower Bound. They therefore argue for a higher inflation target to give the central bank more room for manoeuvre.

    I can see their point without agreeing with it, but you correctly point out that the central bank can still expand the monetary aggregates at any given nominal rate, and this important point is often overlooked. In this sense, monetary policy is never powerless, however low nominal rates might be.

    But advocates of activist monetary policy generally overlook the point that the "power" of monetary policy is, in general, a destructive one.

  • Mattyoung

    The system is a little different since Ben introduced the IOER and the Fed up group never reworked their central banking theory to reflect the change. So they do not get that raising rates just switches the seigniorage stream from government to deposit rate. They are free to make stuff up about that, but they didn't.

    What is the difference between seigniorage and IOER? Mathematically it is exactly the cost of funding the Fed and its staff . So Ben sets up this economy in which the main purpose is to keep the Fed funded to eternity. We will, collectively, discover the salaries of the Fed staff, each year, with great effort. Why bother at all?

  • Joesph Constable

    Banks do not and cannot lend out their reserves. Or buy Treasuries for that matter. What can banks do with their reserves if the were not getting interest on them? How can M0 fuel faster M2 growth if the FRB didn't pay that interest.

    • If liquidity sufficient to maintain the price level is provided "at the right time", then money demand wouldn't grow so much, and lending opportunities outside the distressed industry would continue with similar interest rates.

      Put another way, a speculative bubble collapsing in one sector metastasises throughout the financial system because the overly rigid financial regulations (largely under control of a central bank) prevent the automatic conversion of increased money demand into increased liquidity, thereby exasperating deflation.

      A better question is, given the general procyclical regulatory regime we will be stuck with, where "at the right time" is never likely to happen, does the Fed Up plan offer any advantages?

    • Mint

      Banks can lend out excess reserves, i.e. what they keep at the FRB that exceeds 10% of their deposits.

      It used to be roughly zero for many decades (i.e. they used to lend every dollar they were allowed to), but that excess shot up during the recent recession, and hasn't gone back to zero since. Banks can't find enough safe borrowers to lend to.

  • “Absent offsetting higher interest on excess reserves, quantitative easing is capable in principle of providing all the monetary “looseness” needed.”

    I have a question. Households and businesses want to increase their cash during a recession, but not necessarily using debt. They rely on savings, that is, reduced consumption. In many cases they have too much debt and are trying to pay it down. So how does lower interest rates to encourage borrowing help people who want to pay down debt and save more?

    • Mint

      Lower rates can make a big difference if you have a variable mortgage, or are renewing your fixed mortgage soon. Otherwise, you can only pay down debt the hard way: cut expenses or increase income.

  • Mint

    I hope the author and others are still responding to new posts.

    First of all, the argument that the Fed prevented M2 growth is extremely weak. Assuming 2% inflation, 0.25% IOER simply means the floor for banks was -1.75% real instead of -2% real. The difference between the two pales in comparison to the -3% we'd have with a higher inflation target. Perhaps more importantly, the excess M0 wouldn't even be there if the rest of the economy wasn't parking so much money at the banks, and they felt almost the full -2%.

    I think the simplest way to mitigate the costs of a 3% inflation target is to offer each debt-free citizen guaranteed interest on savings (matching inflation) up to, say, $100k (this figure will grow with inflation). If you have debt, then you have to pay that off first, or else the system will be abused. Of course, minimum wage will also increase with inflation.

    The fact that we even have excess reserves (on top of the rapidly growing bank deposits) is proof that the rich now have more money than they know what to do with. They won't invest it unless they see more demand for business to attack, and they can't be expected to consume/donate that much themselves. A penalty of -2% for savings isn't enough of a deterrent for leaving money idle, but maybe -3% is, and -5% certainly will be.

    • George Selgin

      The evidence that IOER led banks to accumulate excess reserves (just as it was originally intended to to), thereby severing the traditional connection between growth in B and growth in M2, is in fact overwhelming, notwithstanding a priori preconceptions regarding how "small" IOER was. (What matters is that IOER has been, almost from the start, above corresponding short-term market rates, making banks' opportunity cost of reserve holding negative.)

      I offer plenty of evidence, and challenge alternative attempts to explain the vast accumulation of excess reserves, here: https://financialservices.house.gov/uploadedfiles/hhrg-115-ba19-wstate-gselgin-20170720.pdf