The justice of a low predictable inflation rate

14 May

From Robert Miller:

Central banks in most advanced economies are committed, often by law, to maintaining price stability. Such banks generally implement this commitment by announcing a target inflation rate, commonly 2 percent per year, and then using monetary policy tools (generally open market operations, that is, buying or selling government securities) to adjust the supply of money in the economy to attain the target rate. Most major central banks, including the European Central Bank, have long maintained a target inflation rate of 2 percent. The United States Federal Reserve long resisted disclosing a target inflation rate, but it finally announced in 2012 that it too would target a 2 percent inflation rate.

Writing at Public Discourse, Samuel Gregg argues that such a policy “raises many questions that have as much to do with justice as with their impact on economic life.” To be clear, Gregg is all in favor of price stability; he does not recommend (who could?) the erratic monetary policies that have long plagued the economies of, for example, many Latin American countries. Rather, Gregg suggests that perhaps “constancy in a given currency’s average purchasing power is the best we can aim for”—that is, price stability with zero inflation. I am happy whenever intelligent and responsible scholars like Gregg turn the conversation to monetary policy, but I have a more sanguine (and conventional) view than Gregg does of positive target inflation rates, and I write today to explain why.

Let’s start with why central banks set low but positive inflation targets. Gregg suggests that central banks adopt such policies because “they provide a small, permanent stimulus for short to medium-term employment without letting the full-blown inflation genie out of the bottle.” I don’t think this is the reason; it is certainly not the stated rationale of the Federal Reserve. Nor, in my opinion, is this reason supported by the macroeconomic theories on which central bankers rely in setting monetary policy. Rather, following the foundational work of Milton Friedman and Anna Schwartz in their monumental A Monetary History of the United States: 1867-1960, the available empirical evidence tends to show that central bank monetary actions can indeed stimulate economic activity but only to the extent that changes in the money supply are unanticipated by economic actors. Inflation consistent with a publicly announced targeted inflation rate will, of course, be anticipated and thus be useless for stimulating economic activity.

Why does it matter whether the inflation is anticipated? The most commonly accepted explanation relies on Friedman’s price misperception model. In this model, increases in the money supply cause all prices to rise (that is, cause inflation), but workers, although they see their own wages rising, do not fully appreciate that all other prices are rising proportionately; they thus believe (mistakenly) that working produces greater rewards in terms of real goods and services than it previously had, and so they work more, thus increasing overall output in the economy. Once workers realize that all prices have risen proportionately and that work is not really more remunerative than it had been in the past, they work less, and labor inputs fall back to the previous level. As Harvard economist Robert Barro puts it,

The effects of an increase in the nominal quantity of money, M, on these real economic variables [such as the real wage rate and the quantity of labor input] are only temporary. In the long run, an increase in M leaves the real variables unchanged.

This idea is known as monetary neutrality. Assuming it’s correct, a creditable announcement by a central bank that it will target a certain inflation rate will have no effect on real economic variables like employment. Hence, when central banks set a positive inflation target, they are not attempting to stimulate economic activity.

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