Why Inflation Targeting Is Like a Norwegian Blue Parrot

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by: Dirk Ehnts

The Congressional Oversight Panel warns:

The Panel found that “a significant wave of commercial mortgage defaults would trigger economic damage that could touch the lives of nearly every American.” When commercial properties fail, it creates a downward spiral of economic contraction: job losses; deteriorating store fronts, office buildings and apartments; and the failure of the banks serving those communities. Because community banks play a critical role in financing the small businesses that could help the American economy create new jobs, their widespread failure could disrupt local communities, undermine the economic recovery and extend an already painful recession.

Maybe this is why Olivier Blanchard of the IMF argues for higher inflation in the future:

IMF survey online: Central banks have chosen low inflation targets, around 2 percent. In your paper, you argue that maybe we should revisit this target. Why?

Blanchard: The crisis has shown that interest rates can actually hit the zero level, and when this happens it is a severe constraint on monetary policy that ties your hands during times of trouble.

As a matter of logic, higher average inflation and thus higher average nominal interest rates before the crisis would have given more room for monetary policy to be eased during the crisis and would have resulted in less deterioration of fiscal positions. What we need to think about now is whether this could justify setting a higher inflation target in the future.

The argument “higher average inflation and thus higher average nominal interest rates before the crisis would have given more room for monetary policy to be eased during the crisis” is completely bogus. It’s like saying that old people should have higher blood pressure, since falling blood pressure is often followed by death. Or, in economese: How can you assume that the financial crisis would have happened even with higher inflation rates and higher interest rates?

Spain and Ireland had relatively high inflation, but lack autonomous monetary policy. Somehow Blanchard assumes that a fall in demand in an economy with high inflation would not lead to deflation. I would like to see a proof of that argument, empirical or theoretical.

By the way: Why of all people does Paul Krugman fall for this idea? I mean, higher inflation is probably a good idea right now, but not because there is more room to cut nominal interest rates! Also, Knut Wicksell would be spinning in his grave – high interest rates and high inflation at the same time (source: Dallas Fed, my highlighting) has not been his idea of how the economy works:

This is Wicksell’s “cumulative process” model of business cycles. When the loan (market) rate of interest is below the natural rate, the demand for loans by entrepreneurs exceeds the quantity of savings in the economy. Banks expand credit by creating checking accounts (demand deposits) rather than by supplying savings, and an economic expansion occurs that must, other things being equal, drive up prices. Although Wicksell’s process does not demand a monetary change to begin, it is perfectly consistent with—and this is what the Austrians later emphasized— a lowering of the market interest rate through central bank monetary injections.

Today, inflation-targeting is a Norwegian blue parrot. Even the IMF knows by now.

Disclosure: No positions