Targeting Two

In the Washington Post, Jared Bernstein asks why the Fed's inflation target is 2 percent. "The fact is that the target is 2 percent because the target is 2 percent," he writes. Bernstein refers to a paper by Laurence Ball suggesting that a 4% target could be preferable by reducing the likelihood of the economy running up against the zero lower bound on nominal interest rates.

Paul Krugman chimes in, adding that a 2 percent target:

"was low enough that the price stability types could be persuaded, or were willing to concede as a possibility, that true inflation — taking account of quality changes — was really zero. Meanwhile, as of the mid 1990s modeling efforts suggested that 2 percent was enough to make sustained periods at the zero lower bound unlikely and to lubricate the labor market sufficiently that downward wage stickiness would have minor effects. So 2 percent it was, and this rough guess acquired force as a focal point, a respectable place that wouldn’t get you in trouble. 

The problem is that we now know that both the zero lower bound and wage stickiness are much bigger issues than anyone realized in the 1990s."

Krugman calls the target "the terrible two," and laments that "Unfortunately, it’s now very hard to change the target; anything above 2 isn’t considered respectable."

Dean Baker also has a post in which he explains that Krugman's discussion of the 2 percent target "argues that it is a pretty much arbitrary compromise between the idea that the target should be zero (the dollar keeps its value constant forever) and the idea that we need some inflation to keep the economy operating smoothly and avoid the zero lower bound for interest rates. This is far too generous... Not only is there not much justification for 2.0 percent, there is not much justification for any target."

I'll add three papers, in reverse chronological order, that should be relevant to this discussion. Yuriy Gorodnichenko, Olivier Coibion, and Johannes Wieland have a 2010 paper called, "The Optimal Inflation Rate in New Keynesian Models: Should Central Banks Raise their Inflation Targets in Light of the ZLB?" They say the answer is probably no:

The optimal inflation rate implied by the model is 1.2% per year which is within, but near the bottom, of the range of implicit inflation targets used by central banks in industrialized countries of 1-3% per year. In addition, the welfare loss from higher inflation rates is non-trivial: raising the target rate from 1.2% to 4% per year is equivalent to permanently reducing consumption by nearly 2%. In short, using a calibrated model of the U.S. economy which balances the costs of inflation arising from infrequent adjustment of prices against the benefit of reducing the frequency of hitting the ZLB yields an optimal inflation target which is certainly no higher than what is currently in use by central banks.

Their model balances the costs of inflation that arise from infrequent price adjustment against the benefit of reducing the frequency of hitting the zero lower bound. In the model, at 0 percent inflation, the zero lower bound would be binding 15 percent of the time, while at 3.5 percent  inflation, the bound would bind 4 percent of the time, but the costs from price stickiness would be high. They compute that welfare would be maximized at 1.2 percent inflation.

Another paper, which I would guess influenced some people at the Fed, is by George Akerlof, William Dickens, and George Perry in 2000. They build a model in which some agents in the economy are "near rational" instead of fully rational in the way they think about inflation:
"when inflation is low it is not especially salient, and wage and price setting will respond less than proportionally to expected inflation. At sufficiently high rates of inflation, by contrast, anticipating inflation becomes important and wage and price setting responds fully to expected inflation."
As a result, there is some moderate positive level of inflation that is optimal for employment. They estimate that this optimal rate of inflation is between 1.6 and 3.2 percent.

The first few sections of the Akerlof et al. paper are interesting in that they discuss how psychologists and economists have different approaches to the way they think about people's decisionmaking. The model in the paper tries to take a more realistic, but still relatively simple, approach to how people make decisions based on their inflation expectations. I wouldn't be surprised if this paper influenced the adoption of the 2% target.

And then, of course, is John Taylor's 1993 paper, "Discretion versus Policy Rules in Practice." Just about everyone at the Fed must have read it at some point. Here's his original Taylor rule from page 202:

If GDP is at target, the rule suggests raising the federal funds rate if inflation is above 2 percent and lowering it if inflation is less than 2 percent. He calls 2 percent the Fed's implicit target. Later he writes that "Given biases...in measuring prices, the 2-percent per year implicit inflation target rate is probably very close to price stability or zero inflation" (p. 210). This is probably where Krugman gets his argument that 2 percent "was low enough that the price stability types could be persuaded, or were willing to concede as a possibility, that true inflation — taking account of quality changes — was really zero." More importantly, this paper probably helped propagate the idea that the Fed has had an implicit 2 percent inflation target since at least the early 1990s. So when deciding on an explicit target in 2012, 2 percent seemed a natural choice.

(New) Economic Thinking

In "Can New Economic Thinking Solve the Next Crisis?," Mark Thoma writes:

There has been quite a bit of criticism directed at the tools and techniques that macroeconomists use, e.g. criticism of dynamic stochastic general equilibrium (DSGE) models, but that criticism is misplaced. The tools and techniques that macroeconomists use are developed to answer specific questions. If we ask the right questions, then we will find the tools and techniques needed to answer them.  

The problem with macroeconomics is not that it has become overly mathematical – it is not the tools and techniques we use to answer questions. The problem is the sociology within the economics profession that prevents some questions from being asked. Why, for example, were the very questions we needed to ask prior to the Great Recession ridiculed by important voices within the profession?

Since I didn't start studying economics until the Great Recession was in full swing, I don't have a full perspective on "new economic thinking" compared to old, or on what it was like to be in the economics profession prior to the Recession. I only gain second-hand perspective through reading and through studying economic history (which at Berkeley, coincidentally, is largely supported by the Institute for New Economic Thinking).  Thoma's article was prompted by the Rethinking Economics conference, but for me, I'm still learning how to think economics, much less rethink it.

One course that was particularly helpful in shaping my economic thinking was an elective on Empirical Macrofinance taught by Atif Mian. He made a point on one of the first days of class that really stood out. He told us not to see what questions we could answer with the data we have, but rather, to start with the question, and then think about what data we needed to answer it. More often than not, we'd need microdata. Not a problem! We are not in a data-scarce environment!

Mian's work with Amir Sufi on the role of household debt in the Great Recession is a great example of both his point and Thoma's point: start with the question, then choose your tools, techniques, and data. I realize this is easier said than done (trust me, I really do, after spending the last few years trying to implement it in my dissertation), but to me, that's just economic thinking.

Speaking of my dissertation, I'm preparing to go on the job market this year, which is why the blogging has been a bit less frequent! While the preparation is a lot of work, I am fortunate to be very enthusiastic about my research, because I did start with questions I care about, so working on it is a joy, even if it takes away blogging time. Eventually I will blog about my research, just not quite yet.