Applying ‘Great Inflation’ policies on inflation targeting to the Great Recession

Each week, Symposium Magazine invites an author to guest-blog. This week’s featured piece is Why Central Bank Transparency May Be Overrated by Brigitte Granville.According to The New York Times (Oct. 26), Harvard economist Ken Rogoff now favors pushing inflation as high as six percent per year, for some years, to simulate the economy. I usually place myself in the opposite economic camp, which distrusts playing with inflationary fire on grounds that it can easily get out of control, with the poorest and most vulnerable in society suffering the most while long-term growth prospects are compromised.

At the same time, I would argue that Rogoff’s prescription could help if pursued in the right way — that is, by applying the lessons of successful inflation targeting as practiced in the 1980s and onwards. Put another way, and as explained more fully in my recent book Remembering Inflation, the macroeconomic thinking and policy practice that overcame the Great Inflation of the 1970s is very relevant to present-day problems – even though inflation seems the least of policymakers’ worries.

Inflation targeting has proved to be the most widely used and effective regime for achieving price stability – or, more specifically, holding inflation at a rate deemed desirable (typically around two per cent) and ensuring that any deviations from that rate are mild and short-lived. This success owes much to the way that a declared inflation target creates an effective “working” nominal anchor for a rules-based monetary policy framework. And success is self-reinforcing, since the key to restrained inflationary expectations is the track record of stable low inflation during previous years.

To maintain that credibility as a bulwark against inflationary expectations spinning out of control, the central bank should announce an explicit increase in the inflation target – thereby maintaining the policy framework oriented toward long-term price stability by making clear that once growth had revived, the target would be adjusted downwards again.

The central objection to this approach is that the credibility of inflation targeting depends on never altering the target. This view argues that after a first change in the target, the public would assume that other changes could come in quick and unpredictable succession. This is not, however, the way in which credibility is understood by the best thinkers on monetary economics. Writing in the American Economic Review in 2000, Alan Blinder argued that a central bank must match deeds to words: “A central bank is credible if people believe it will do what it says.” But he also conceded there is “no generally agreed-upon definition” of credibility.”

Another distinguished macroeconomist, Michael Woodford, has argued that the key to success here lies precisely in the target. In an article in 2011, he called for “specifying the size of any permanent price level increase [to] avoid an increase in uncertainty about the long run price level. This in turn would ward off an increase in inflation risk premiums that might otherwise counteract the desirable effect of the increase in near term inflation expectations.”

In short, the tried and tested techniques of inflation targeting could deliver the combination of the temporarily higher inflation rates that are now desirable while anchoring inflationary expectations. This approach might be even more necessary in the euro-zone, where the impossibility of devaluation and fiscal stimulus leaves the ECB as the only independent actor. On its own initiative, the ECB could increase its inflation target for a stated period — for instance, to four percent for the next five years, as proposed in a paper by Stephanie Schmitt-Grohé and Martín Uribe in the summer issue of the Journal of Economic Perspectives.

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