Inflation targeting vs inflation trade-offs: What’s the score?

Note: Other posts in this discussion are available under the tag “inflation debate“.

After placing down all the trade-offs between inflation and output, it was not clear that fighting inflation was necessarily the best cause of action. Although there are definitely costs from inflation, there are also costs from fighting it. Ultimately, it would be nice to have a method of dealing with inflation that got rid of these trade-offs, and just made us better off. One way we could try and do this is through explicit inflation targeting.

We have touched on the benefits associated with inflation targeting before here and here. However, now we will try to tie these benefits down amongst the costs and trade-offs associated with inflation and inflation fighting.

Expectations, expectations, expectations

When describing what inflation was we came to the conclusion that the true, long-term, issue of inflation was driven primarily by expectations. If price setters expect high inflation, they will increase prices in a way that is consistent with that, leading to inflation. Given this conclusion, the process of increasing interest rates to beat down inflation appears to be somewhat overkill – surely there is someway that we could change peoples expectations such that we don’t fall into this price-setting, inflationary, spiral.

Higher interest rate policies lower inflationary expectations in the following way. By increasing interest rates, domestic economic activity and the quantity of money demanded both fall, leading to lower levels of price pressure (from the demand side of the economy). (Note, this effect dominates any cost pressures from higher interest rates on the supply side of the economy – this makes sense as interest rate payments are a fixed cost, and so should not influence price setting behaviour!).

As higher interest rates reduce growth in the price level within some relevant contract setting period of time, price setters expect prices to lift by a smaller amount when the central bank is active in this sense. As they expect prices to rise by less, they put a smaller inflation premium onto their fixed price contracts, which in turn helps lead to lower inflation, which leads to persistently lower inflation premiums being set – viola, inflation expectations are lower!

What does this have to do with inflation targeting

Well, if the central bank has a reputation for keeping inflation low, then people will form expectations that inflation will stay around this level, and in turn this will lead to lower inflation outcomes – independent of any central bank action!

In an idealised sense, a perfectly credible central bank would not suffer from the trade-off between inflation and output or output variability outside of macro-economic shocks. As a negative (positive) demand side shock should lead to a reduction (increase) in interest rates anyway, the only problem that these Central Banks are left with is supply side shocks.

Now, if we have a temporary negative supply side shock, and inflation expectations are well anchored (stuck down at a low level), then the central bank still has a relatively easy time of it as they can quickly cut rates to prevent this shock causing too much of a fall in output, and then when the shock has passed they can lift rates again to illustrate their commitment to low inflation (this all serves to lower output variability). Fundamentally, successful inflation targeting allows central banks to take advantage of the short-run Phillips curve in the face of a big supply side shock, reducing output volatility without causing undue price volatility!

As a result, a central bank that has been successful at building an inflation fighting reputation will be able to reduce both output and price variability!

What is the catch?

Although inflation targeting deals with the trade-offs that we mentioned before, it does create a different cost. Ultimately, there is a short-run cost associated with making the central bank credible.

As long as the cost of making the bank credible is sufficiently small (we seemed to believe that it was in the 90’s) then once we have credibility it is something we will want to keep!

This is the hardest thing for the RBNZ at the moment. It wants to keep its credibility, but it is trying to respond to the dual supply shocks of drought and rising oil prices. With the government threatening the Reserve Bank Act, and the constant changing of the Policy Targets Agreement, the Bank is currently stuck between a rock and a hard place.

So the trade-off we face at the moment is between output variability (mainly downward, and so including some unemployment) in the short-term, versus higher output and price variability and potentially lower output over the long-term.

Up next …

Given the relationship we have discussed between inflation targeting and outcomes we are next going to move on to discussing alternative views (which were discussed by you guys in the initial post) and other issues (such as measurement).

The next inflation post will be on price indices’s and measuring inflation. Once we’ve figured out how to look at the data and figure out what the data is telling us we can move on to discussing more specific types of inflation targeting (eg targeting nominal wages), before discussing the alternatives that have been raised.