Thursday, September 5, 2019

Cost & Benefit Analysis: Inflation Targets

For the past two decades, monetary regimes have implicitly and explicitly targeted a low rate of inflation of ~2-4%. Targeting depreciation has led to criticisms as to why the monetary authorities are devaluing a nation's currency. However, people often fail to take into consideration to costs and benefits of different inflation targets.

Low Negative Inflation

Friedman was someone who actually argued that the optimal rate of inflation was negative. Spending cash has welfare benefits and, in theory, monetary policy should be used to maximize those benefits, i.e. reduce the cost of cash. In this case, the cost of cash in the nominal interest rate, which represents the risk-free rate of return. The real interest rate is determined by our advancements in technology, productivity, supply-side policies(which effect the previous two examples) and culture, and is positive in the long run. If real interest rates are positive, and nominal interest rates are zero, then the optimal inflation rate must be negative(to have a stable monetary policy/no tightness) since the real interest rate equals the nominal interest rate minus the inflation rate.  

Another POV: For every dollar, you have in cash or some account, you are foregoing buying a risk-free bond and earning interest on that bond that can be used to boost consumption and investment in the long run. That foregone interest is one cost of holding cash.

Assume that a bond earns a real return, r. The optimal rate of inflation that removes the difference between bond returns and cash returns sets inflation = -r. That is, the optimal rate of inflation is actually deflation at the rate of r% per year. At the deflation rate, you are no worse off holding cash than holding bonds. So, the central bank should aim for stable and gradual deflation, otherwise known as "The Friedman Rule".

Zero Inflation

In the news, you'll see a lot of people in the business/finance industry advocate for lower rates of inflation. The low cost of borrowing is one factor, but a concept is known as 'menu costs' is another. Firms face costs in changing their prices. When a firm changes the price it charges for its products, it just updates its online catalog, replaces the stickier prices on its shelves, etc. These costs are known as 'menu costs', the idea that you have to create a new 'menu' when you change the price of a good(in this case due to inflation changing prices annually). Menu costs are empirically quite large which can be a hassle for many firms. An ideal monetary regime would be one that targets an inflation rate of 0% to reduce menu costs. They would still change their prices relative to demand and shocks, but they won't have to worry about the constant and rapid change of price due to inflation. Targeting a non-zero rate of inflation also serves as a hassle due to the tax code. Inflation serves as a distortion on the real after-tax return on investment; minimizing these distortions guides us towards an optimal rate of 0%.  

Low Positive Inflation

It's not possible to reduce nominal interest significantly below zero(you can go a little), so in times of an economic downturn, if your rates are at zero you've given yourself less room to navigate during a recession. Now, the Fed doesn't actually run out of ammunition as it could simple, in theory, just buy as many assets as it wants, implement QE or invoke hefty measure by using 13.3(13.3 pertains to the U.S. in specific), but the political feasibility of doing these things may not be possible or they could be illegal -> see Japan. This is a phenomenon known as the Zero Lower Bound(ZLB). Suppose the normal inflation rate is 4% and the normal nominal interest rate is 6%. If we enter a recession, the central bank can cut interest rates by 600 basis points before approaching the ZLB. If the normal inflation rate is 2% and the normal nominal interest rate is 4%, then the central bank only 400 basis points worth of cuts before it hits the ZLB. If the normal inflation rate is 0% and the normal nominal interest rate is 2%, then the central bank can only cut interest rates by 200 basis points before hitting the ZLB. Given this information, a higher inflation target gives the central bank more room to stimulate during a recession given political feasibility as a factor as to why it wouldn't be able to stimulate by more 'extreme' means.

There's also something called the grease effect. Wages are very sticky downwards, if your boss cuts your salary despite you having done nothing "wrong", you would probably go into a frenzy. However, firms face business disruptions in both directions, so if a firm is underperforming in on year, it has no way to reduce costs short of firing people, which is bad for the firm, the employee, and the entire economy. Consequently, having some inflation gives all firms some flexibly, which creates some level of efficiency. 


Since it's nearly impossible for a central bank to do "whatever it wants" during a recession and since deflation, especially unexpected deflation, is dangerous and responsible for the worse economic downturns in history, such as the Great Depression, modern central banks have weighed all considerations and tend to target a slightly positive interest rate of 2-3%. Some people want it to be pushed up to 4% and others, like myself, would prefer a nominal GDP targeting schematic which would also have an implicit positive inflation target.

The key reasoning from a nominal GDP Target are due to 3 things main things

Countery-cyclical policy
Financial Market Efficiencey
and a stronger Phillips Curve

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