The blogpost points that IMF economists – Olivier Blanchard, Giovanni Dell’Ariccia, and Paolo Mauro – have written a new paper on rethinking about macroeconomic policy.
I have not read the paper but the contents say it all:
II. What We Thought We Knew
A. One Target: Stable Inflation
B. Low Inflation
C. One Instrument: The Policy Rate
D. A Limited Role for Fiscal Policy
E. Financial Regulation: Not a Macroeconomic Policy Tool
F. The Great Moderation
III. What We Have Learned from the Crisis
A. Stable Inflation May Be Necessary, but Is Not Sufficient
B. Low Inflation Limits the Scope of Monetary Policy in Deflationary Recessions
C. Financial Intermediation Matters
D. Countercyclical Fiscal Policy Is an Important Tool
E. Regulation Is Not Macroeconomically Neutral
F. Reinterpreting the Great Moderation
IV. Implications for the Design of Policy
A. Should the Inflation Target Be Raised?
B. Combining Monetary and Regulatory Policy
C. Inflation Targeting and Foreign Exchange Intervention
D. Providing Liquidity More Broadly
E. Creating More Fiscal Space in Good Times
F. Designing Better Automatic Fiscal Stabilizers
This is a very neat index. It summarises most of the issues and lessons from the crisis in one go.
But some policy solutions are different from the ones you get to read. Especially the proposal for a higher inflation target, designing automatic stabilizers for downturns and understanding why some central banks prefer to target exchange rates despite being called inflation targeters.
You suggest that before the global recession, policy makers had become too complacent and relied too much on a single tool, monetary policy.
Blanchard: Yes. Even monetary policy had become extremely simplified. There was sense all we had to look at the policy interest rate and that was it. We thought we had come to a level of detail. That wasn’t quite right.
The most striking suggestion you make is that nations should consider aiming for a higher rate of inflation,
Blanchard: Before the crisis, if you talked to policy makers, the idea of being stuck at zero interest rate would have struck them as very unlikely. That happened in Japan. But most people convinced themselves that the Japanese didn’t know what they were doing.
Now we realize that if we had a few hundred extra basis points to rely on, that would have helped. We would have had to rely less on fiscal policy. So it would have been good to start with a higher nominal rate. The only way to get there is higher inflation.
Policy makers have generally chosen a 2% (inflation rate target). But there was no very good reason to use 2% rather than 4%. Two percent doesn’t mean price stability. Between 2% and 4%, there isn’t much cost from inflation.
So should we change the inflation target?
Blanchard: If I were to choose inflation target today, I’d strongly argue for 4%. But we have started with 2%, so going from 2% to 4% would raise issues of credibility. We should have a discussion about it.
What’s an inflation level we should fear?
Blanchard: When you get to high numbers – 10% and above– people see uncertainty. They don’t know to know what’s gong to happen. You don’t how to plan from retirement.
Would you need to get an international agreement among central bankers on a higher inflation target?
Blanchard: Going international would increase credibility. It’s probably not needed but it would be helpful.
This is very interesting stuff – a higher inflation target. In this crisis, 2-3% inflation target is seen as very low and not helpful in zero bound rates. A higher inflation target (around 4%) makes sense both ways. first it does not hurt growth and second helps in zero bound rates. But so far, I have mostly seen inflation targeting central banks of developed economies defend their 2-3% inflation target. At most I have read Janet Yellen saying she would prefer inflation target for US to be raised from 1.5% to 2%!
Adam Posen said he did not see inflation of 4,5,6% hurting growth. And like Blanchard says inflation above 8%-10% is what hurts growth.
IMF Survey Magazine also has an interview of Blanchard:
IMF Survey online: What are your conclusions so far?
Blanchard: The basic elements of the pre-crisis policy consensus still hold. Keeping output close to potential and inflation low and stable should be the two targets of policy. And controlling inflation remains the primary responsibility of the central bank. But the crisis forces us to think about how these targets can be achieved.
The crisis has made clear, however, that policymakers have to watch many other variables, including the composition of output, the behavior of asset prices, and the leverage of the different participants in the economy. It has also shown that they have potentially many more instruments at their disposal than they used before the crisis. The challenge is to learn how to use these instruments in the best way. The combination of traditional monetary policy and regulatory tools, and the design of better automatic stabilizers for fiscal policy, are two promising routes.
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 if whether this could justify setting a higher inflation target in the future.
IMF survey online: You argue that we should understand why, in many countries, central banks care more about the exchange rate than they admit, and we should draw policy conclusions. Can you explain?
Blanchard: In many emerging market countries, while monetary authorities describe themselves as inflation targeters, they clearly care about the exchange rate beyond its effect on inflation.
They probably have good reasons to do so. Isn’t it time to reconcile practice with theory, and to think of monetary policy more broadly, as the joint use of the interest rate and sterilized intervention, to protect inflation targets while reducing the costs associated with excessive exchange rate volatility?
This is thought provoking stuff from IMF economistsi Reading the paper become s a top priority.