Tuesday, February 16, 2010

Worth your time 

A very nice review of a discussion on whether we need to rethink macroeconomic policy by setting target inflation rates higher than 0-2% is provided by David Altig. Takeaway:

To be sure, there are plenty of studies suggesting modest increases in the rate of inflation from the levels currently targeted by many central banks would not be problematic�here, for example. But the point is that the evidence is not clear cut that an increase from an average rate of inflation in the neighborhood of 2 percent to the neighborhood of 4 percent would be innocuous. And there is always this element, noted by John Taylor in the aforementioned Wall Street Journal article:

"John Taylor, a Stanford University monetary-policy specialist who served in the Bush administration Treasury department, says that inflation could become hard to constrain if the target is raised. 'If you say it's 4%, why not 5% or 6%?' Mr. Taylor said. 'There's something that people understand about zero inflation.' "

This is not a new story, at least not to me. I co-authored a paper published in 1994 with Hal McClure and Tom Willett in which we argued that the optimal inflation rate was probably zero for most economies if there was a tradeoff of even 1% of GDP growth for a 10% anticipated inflation rate. Developing countries are usually assumed to have a smaller tradeoff. There are non-linearities or threshold effects involved as well. (I don't know of a summary paper that covers the literature and none were obvious from looking on Google Scholar, at least not since Bruno and Easterly [1998]. If anyone knows one, please put in comments.)

Arguing for higher inflation targets at a time like this is a call for cheap credit, which seems like trying to do the same thing we did in 2004-05 while hoping for a different outcome.