The Incentives For Inflation "Targeting"

Now that the furore about Modern Monetary Theory (MMT) has died down (other than the continuous pathetic strawman attacks), I am seeing a downtick in economic theory arguments that I find interesting. People are arguing about the details of fiscal policy and what is happening with inflation, which end up either being political or datamining time series.

One theoretical topic that comes up is the idea of nominal GDP targeting. I have doubts about nominal GDP targeting, the main one being that it is difficult to dislodge something like an inflation target (I am not concerned with the details of the policy framework). In this article, I explain the political attractions of inflation targeting before turning to nominal GDP targeting.

Ye Olde Days

One of the fundamental questions facing paper/electronic money is: why does it have value in exchange? If we go back to earlier Gold Standard frameworks — such as the interwar Gold exchange standard, or the Bretton Woods system — we had a fairly simple answer, even if that simple answer is perhaps misleading. In those systems, a currency could be exchanged for gold, or for a currency that itself was pegged to gold.

Reality was more complex than gold bug propaganda might suggest, at least by the twentieth century. The value of gold in exchange was probably less important than the fact that currencies being de facto pegged against each other, and prices had nominal anchors.

In any event, a gold peg or currency peg offers an easily understood answer to “why does this currency have value in exchange?,” and it creates a constraint on the policy framework. Although the government has some freedom of action in pursuing economic policy, it will either have to respect the peg or devalue (which has a political cost).

Fiat Currencies

As soon as we drop the currency peg, the question comes back. If we look at conventional economic discussions, this is a source of anguish. One either hears calls to new currency peg systems (like the Euro), peg the currency to some collectible that is being hoarded (by the people who are calling for the peg), or we have arcane discussions of the determination of the price level allegedly based on optimal control theory.

From the perspective of MMT, the answer is straightforward: the government should peg an important price in the economy, and build the policy framework around that constraint. The suggested “important price” is the Job Guarantee wage, which then acts as a base of comparison for private sector prices. However, one of the interesting things about MMT debates is that critics are incapable of addressing this rather simple concept. I have browsed through hundreds of “critiques” of MMT that do not address it — or even more ridiculously, the critic thinks that the Job Guarantee is of peripheral importance to MMT. (I may have seen a few outsiders discussions of MMT that address this issue.)

For the rest of this article, I will follow the conventional economists and ignore the MMT policy framing. How to set up the policy framework in that case?

Enter the CPI

Although gasoline price changes cause great stress to ostensible free market supporters, pegging a commodity price is not attractive. But why not try to keep the “cost of living” under control? Since the “cost of living” is a slippery concept, we go with something more concrete, like the Consumer Price Index (CPI).

To the extent that people believe that the CPI is somewhat related to the cost of living, having a policy framework that says that the government will attempt to control (in some sense) the CPI gives a straightforward reason why the currency has value in exchange. Over time, it is meant to have a stable relationship with a basket of prices — either expressed as an inflation rate, or possible a target level of the CPI. (Having a target level for the CPI is not a popular stance, but it had its adherents at the Bank of Canada, and presumably elsewhere.)

A Formal Inflation Target Versus an Inflation Constraint Framework

There are two ways of approaching such a framework.

1. The usual “inflation targeting” framework: there is a formal target for inflation (or CPI level) that is supposed to be respected by central bankers (and/or fiscal policy analysts). Other policy objectives can be pursued, but the central bank will set interest policy to hopefully steer inflation.

2. The government eschews formal economic planning, but indicates what its policy objectives are — along with what are seen as acceptable inflation rates.

Either of these approaches are consistent with saying that “the government’s policy framework respects the inflation constraint.”

What is left? The government has to say that it does not care about the inflation rate. It will pursue other objectives, and if they lead to 30% annual inflation rates, so be it.

Can a Government Afford to Ignore Inflation?

My feeling is that a developed country government could not afford to say that it does not care about the inflation rate — since it would be voted out of office fairly rapidly.

One can argue that something like full employment should be a higher priority — but as MMT proponents argue, with a sensible policy framework (e.g., a Job Guarantee), full employment can be compatible with stable inflation rates. Although I have seen neoclassical economists dispute that assertion, their counter-argument relies upon assuming that their theoretical framework is correct. The only way to test the theories would be to change the policy framework — since observed data comes institutions that have fundamental flaws according to MMT analysis.

The rest of this article is based on my assumption that saying that “inflation does not matter” is not a tenable political strategy. Under that assumption, the remaining question is: do we have a formal targeting system for inflation, or is is informal?

What To Do With Interest Rates?

Under a currency peg system, the central bank needs to manage the peg, which sometimes meant emergency rate hikes to defend the currency parity. The day-to-day management of the currency peg meant that the central bank had a technocratic side. But once a country is de-pegged, all the central bank normally does is set the policy rate and regulate banks (and bail them out when their regulatory attempts fail).

Conventional belief is that interest rate policy is extremely powerful for managing the business cycle. (Not everyone agrees — such as Warren Mosler — but such objections are typically ignored.) Who sets them — a government minister, or bureaucrats at the central bank?

Although most conventional discussion of this topic consists of arguing how bad it would be if politicians set the policy rate, this glosses over the reality that sensible politicians might want to be let bureaucrats take the heat for unpopular decisions. Given the sensitivity of the housing market to interest rates, the bulk of middle class voters say “hooray” when interest rates go down. However, under conventional beliefs, interest rates need to go up as well as down — boo.

In summary, the political path of least resistance is to have the central bank manage interest rate policy (to take the heat for unpopular decisions), handing them some form of mandate in which acceptable inflation levels are outlined. Whether or not the central bank has additional objectives might be viewed as a somewhat cosmetic issue if there is an understanding that inflation control cannot be ignored.

(As for the issue of a mandate, some academic economists have attached a fantasy interpretation to “independence.” It is entirely standard for organisations within a government to have operational independence from governmental ministers. In fact, I worked for an asset manager whose investment decisions were independent of the Quebec government that set it up. But that “independence” does not mean “do whatever you want” - the government gives the “independent” institution a mandate that has to be respected.)

Although I imagine that some people might object to my lumping of informal guidelines about inflation with formal inflation targets, in practice, it is not clear it matters. Most central bankers missed their inflation targets horribly in recent years — and nothing happened as a result. In the absence of actual consequences for missing a target, a target is effectively a guideline. The trend towards a formal rather than informal inflation mandate can be linked to the modern preference for transparency in politics — as opposed to earlier eras, where deals in smoke-filled back rooms were expected.

Are There Alternatives?

Although I have outlined the path of least political resistance, there are alternatives — none of which have strong adherents in mainstream political parties.

• A country could peg its currency. In practice, this is an indirect way of inflation targeting, since the target of the peg likely is managed by a central bank with an implicit/explicit inflation target. Post-Keynesians yearn about a “new Bretton Woods/Bancor” system, but I expect to see a porcine air force before such an option is taken even slightly seriously.

• MMT proponents suggest pegging interest rates at zero and using fiscal/regulatory policy to control inflation. The reality that critics do not even bother discussing such a policy framework is a sign that it is not happening any time soon.

• On the right, there might be calls for privatisation of the central bank (or some other wacky scheme). Given that the people involved are hard money bugs, it is hard to see such a proposal being anything other than a strict gold/inflation/cryptocurrency target. Although such a proposal would have been viewed as laughable years ago, right wing parties might be more receptive now.

Neoclassical Inflation Targeting Propaganda

If one reads mainstream accounts, one will get a quite different tone than what I suggest. Inflation targeting is apparently the culmination of a renaissance in economic theory. I am skeptical about such claims.

If we look at the theoretical justification for inflation targeting, we see that models are picked to get the following conclusions: politicians should not stick their noses into monetary policy. Instead, central bankers are “benevolent central planners” who will determine the path of inflation scientifically. Since central banking is a science — not an art — it is necessary to have a firehouse of central bank money to fund neoclassical monetary research. However, if one believes that economic incentives shape behaviour, such a belief system is entirely predictable.

The replacement of “stabilising the currency peg” with “stabilising CPI” was a natural step, and the trend was started by the Fed-Treasury Accord of 1951. That is, as soon the external constraints of the interwar Gold Standard and wartime finance lifted, the Fed pushed for “independence” to focus on inflation. (Although the U.S. dollar was convertible to gold by foreign governments, this did not in practice constrain U.S. policy makers.)

The only reason that there was a change in tone was that neoclassical economists in early post-war period had decided that they could micro-manage the economy in a scientific manner. Instead of just controlling inflation, they were going to tame the business cycle. When that particular hubristic belief crashed into reality, the mainstream switched to believing that their science could at least tame inflation.

Concluding Remarks

Inflation is a political constraint on macroeconomic policy. To the extent we accept the mainstream belief that interest rate policy is a powerful tool for steering the business cycle and inflation, there is either going to be a formal or informal set of rules tying interest rate policy to inflation. We do not need any stochastic calculus to arrive at that conclusion.

Although central bankers and academics build careers around “optimising” the policy framework, the problem is that without good models that allow us to predict the exact outcomes of policy, the uncertainty about outcomes will always trump the policy specification. For example, central bankers were totally wrong about the inflation and growth outcomes after the pandemic, and no matter what their targets were, they would have missed badly. Most grownups are aware of this, so there is not a whole lot of interest in debates about refining the rules.

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(c) Brian Romanchuk 2022