Wednesday, June 09, 2010

Inflation targeters: yer doing it wrong!

Recent experience has led some people to argue that central bank inflation targets should be raised above their 2% levels in order to better accommodate the problems of monetary policy at the zero interest bound.

Not so fast, say Uribe and Schmitt-Grohe in their new NBER Working Paper, "The Optimal Rate of Inflation" (ungated version available here)

The central goal of this chapter is to investigate the extent to which the observed magnitudes of inflation targets are consistent with the optimal rate of inflation predicted by leading theories of monetary nonneutrality. We find that consistently those theories imply that the optimal rate of inflation ranges from minus the real rate of interest to numbers insignificantly above zero. Our findings suggest that the empirical regularity regarding the size of inflation targets cannot be reconciled with the optimal long-run inflation rates predicted by existing theories. In this sense, the observed inflation objectives of central banks pose a puzzle for monetary theory.

And then there's this:

Furthermore, we argue that the zero bound on nominal interest rates does not represent an impediment for setting inflation targets near or below zero.

A paper on this topic by these authors would obviously be self recommending except that I have read it and am actively recommending it.


ericmc said...

Unexpected inflation is theft. You can pick who you like when you get to run the printing press, but it is still stealing.
Maybe we should have only prime numbers as our inflation targets, maybe not. I am certain these guys don't know either. Good try, but lets stick with the knowable until people stop putting the quotes around our Nobel Prize ehh?

Norman said...

I'll have to go through my papers now, but I remember a presentation at OU in which the costs of unexpected deflation are higher than those of unexpected inflation. In this context, the author found that the optimal target was around 1%. The idea of optimal deflation still sounds peculiar to me, so I'll have to take a look at this paper in more detail.

Angus said...

Norman, I think that presentation was by Jinil Kim. Does that sound right?

Eric, the point of the paper is that according to a range of different theories, inflation targeting central banks have their targets set too high, not too low. Not sure why that is bothering you. BTW, I am not a subscriber to the our Nobel isn't real viewpoint.

ericmc said...

I should really have set my comment to clash with the point of the post. You know how people tend to talk past each other when something is bothering them.
Still, I swear that the answer is likely unknowable.

The Discretionary Ruler said...

Do the names Barro & Gordon ring a bill? Hint: They're not a musical act from the '60s.

Norman said...

Right. I just looked up the paper:

''How Much Inflation is Necessary to Grease the Wheels?'' Jinill Kim and Francisco Ruge-Murcia, Journal of Monetary Economics, vol. 56 (2009), pp. 365-377.

It looks like the optimal inflation suggested by the model is lower in the final version than I remember the presentation discussing. From the abstract:

"[...] Econometric results indicate that nominal wages are downwardly rigid and that the optimal level of grease inflation for the U.S. economy is about 0.35% per year, with a 95% confidence interval ranging from 0.04% to 0.87%."

So the target should still be positive, but certainly lower than 2%.