Inflation targeting is a means to an end – full employment and higher GDP growth. Koichi Hamada asks if higher prices, like higher unemployment, implies economic and social costs, why should the monetary authorities be wanting that?

By Koichi Hamada*

The United States, Europe, and Japan are all making positive economic strides. In the US, the unemployment rate is falling, and now stands at just over 4%. Unemployment remains high in the eurozone, at close to 9%, but that still represents significant progress from the past decade or so. And Japan has achieved virtually full employment, with labor demand so high that new graduates are able not just to find jobs, but to choose them.

Yet there is one key area where progress seems to be lagging: inflation. While the US consumer price index reached 2.2% in October, the European Central Bank and the Bank of Japan have so far been unable to meet their targets of roughly 2% inflation, with the eurozone’s average annual price growth hovering around 1.5% and Japan’s firmly lodged in the 1% range.

There are good reasons to strive to meet the inflation target. Money markets would be rid of near-zero interest rates. Concerns about currency appreciation damaging export competitiveness would be assuaged, as globalization and artificial intelligence continue to create competition for workers. And the expansionary monetary policy pursued by the world’s major central banks in recent years would be vindicated.

Yet when it comes to ordinary people’s wellbeing, meeting the inflation target is not always the best option. Of course, reining in high inflation is beneficial, as it preserves the value of existing money. But raising below-target inflation to 2% leaves people worse off, as it causes their savings to lose value continuously, thereby undermining their prosperity.

The late Arthur Okun, who was one of my professors at Yale before serving as Chair of US President Lyndon Johnson’s Council of Economic Advisers, created the so-called misery index, which goes beyond headline GDP growth or the unemployment rate to provide insight into how the average citizen is faring economically. Okun’s index – the sum of the inflation and unemployment rates – is based on the assumption that an increase in inflation, like an increase in unemployment, creates economic and social costs for a country.

The reality is that the inflation target is a means to an end – to facilitate full employment and faster GDP growth – not an end in itself. And, at least in Japan, substantial progress toward that end has been made, despite the failure to meet the Bank of Japan’s inflation target. Signs of full employment in the market for permanent workers could set the stage for a moderate wage-price increase. That was not the case before 2013, when the implementation of Japanese Prime Minister Shinzo Abe’s economic-reform program, so-called Abenomics, ended a period of austere monetary policy.

But this has not deterred critics of Abenomics from harping on the non-fulfillment of the inflation target. The question is why.

Not long ago, I posed that question to a monetary-policy authority (whose name I am not at liberty to divulge). Rather than provide a straightforward answer, he replied that it was “tricky,” finally landing on the statement that, no matter how low the unemployment rate, the inflation target should be pursued.

This kind of thinking is common among economists, particularly the generation swept up by the “rational expectations” revolution in macroeconomics. This cohort views economics as the study of models, in which agents’ expectations can be assumed to be rational and consistent with the model. From this perspective, inflation expectations can be assumed to be either ideal predictions of the future, or at the very least rational ones, with their accuracy and precision undermined only by limitations in information received by economic actors.

Older economists thought differently, assuming that most economic outcomes in the real world are the result of behavior that is at least partly irrational, meaning that expectations should be viewed more as reasonable possibilities than near-certainties. Because I belong to the generation taught by old sages – Lawrence Klein, Franco Modigliani, and James Tobin – I think this is a worthwhile assessment – one that should be applied to today’s discussions about monetary policy and inflation.

While it is important to recognize the merits of inflation targeting, the misery index, too, has a role to play in helping us to assess the state of our economies – and the success of our policies.


Koichi Hamada, Professor Emeritus of Economics at Yale, is a special adviser to Japan’s prime minister. This content is © Project Syndicate, 2017, and is here with permission.

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17 Comments

Not long ago, I posed that question to a monetary-policy authority (whose name I am not at liberty to divulge). Rather than provide a straightforward answer, he replied that it was “tricky,” finally landing on the statement that, no matter how low the unemployment rate, the inflation target should be pursued.

This kind of thinking is common among economists, particularly the generation swept up by the “rational expectations” revolution in macroeconomics. This cohort views economics as the study of models, in which agents’ expectations can be assumed to be rational and consistent with the model. From this perspective, inflation expectations can be assumed to be either ideal predictions of the future, or at the very least rational ones, with their accuracy and precision undermined only by limitations in information received by economic actors.

Older economists thought differently, assuming that most economic outcomes in the real world are the result of behavior that is at least partly irrational, meaning that expectations should be viewed more as reasonable possibilities than near-certainties. Because I belong to the generation taught by old sages – Lawrence Klein, Franco Modigliani, and James Tobin – I think this is a worthwhile assessment – one that should be applied to today’s discussions about monetary policy and inflation.

Moreover:

THE GLOBAL FINANCIAL CRISIS has done next to nothing to change the convictions of mainstream economists. But the widespread lament over their willful blindness seems misplaced: there was never a realistic possibility that the economics profession would voluntarily break with the methodological sophistication and statistical formalism at the heart of its identity. Far more frustrating than the resilience of orthodox economic thinking is the obsessive concern of more critical minds to prove mainstream economics “wrong,” in the most literal way possible. Perhaps that shouldn’t be too surprising either. After all, it has been the preferred mode of engagement for decades. In a characteristic told-you-so tone, this work chides orthodox economists for their infantile belief in efficient markets and their inability to recognize the systemic nature of financial instability. And it sees these pernicious ideas and equilibrium models as being at the root of our economic troubles. Read more

For Minsky, economic actors or households were essentially balance sheet entities, raising cash by extending promises and using it to make investments. At issue here was not whether the amount of debt taken on was sound in some metaphysical sense, but rather the entirely practical fact that actors need to generate sufficient cash flow from their investments to be able to service their debts. This is what Minsky referred to as a payment or liquidity constraint: whatever our long-term plans, they need to include some provisions to make it to tomorrow. This simple insight gave Minsky a much deeper appreciation of the role of liquidity: whereas Keynes condemned the “fetish of liquidity” as a refusal to commit patiently to the future production of real value, Minsky thought of it as primarily a “survival constraint.” [6] Liquidity is like oxygen: a temporary absence of it will kill off even the most robust organism, cutting short what might have been a long and productive life.

Hmmmmm..

The cross currency basis swap is somewhat unique in that by fixing exchange values at both the outset and back end, it reveals purely financial perceptions in its values and changing values about the differences in interest payments. For example, in the 1990’s the basis swap for Japanese banks (again, not companies) was structurally negative, meaning that they had to pay a premium to swap into dollar funding because of negative perceptions of creditworthiness. This is the legacy of the downside of the “global dollar short”, as Japanese banks had accumulated large dollar asset positions (long US$ assets, short US$ funding) leaving them susceptible to such vagaries in dollar funding, whether repo or basis swaps or anything else someone on Wall Street or in London might dream up that wasn’t gold or actual cash… Read more , more and more

Fed arranges ~$12 billion liquidity swap for some needy, dollar short central bank, for the week ending 27 December 2017 - View section 2, in addition to liquidating/relocating $31 billion Fed custody US Treasury securities over the last three weeks.

But raising..... inflation to 2% leaves people worse off, as it causes their savings to lose value continuously, thereby undermining their prosperity.

Obvious isn't it! Yet that is the madness 'we' pursue. In the mid 19th century, wages and prices remained 'fixed' for 70 odd years, and that was a time of huge technological and social advancement. Why are we so afraid of static metrics today? Ah, yes....Debt.....

Debt indeed. Debt has made useful idiots of us all, me included. Clever lot those bankers, they just do their job and we come running for more.

But if inflation was running higher then interest rates would be higher and the only savers worse off would be those stashing it under their mattress.

I found it very revealing that there is not even one mention of debt/debt burden, or the role that credit growth/contraction etc...plays in regards to GDP growth and the economy.
No mention of the implications of Central Banks evermore DEEP intervention into financial markets and the economy, with ever lessening impact.
This guy is a Yale professor of economics.

Last October, we held a seminar entitled “Debt and Delusion: Lessons Unlearned”. Some of you were
present, so a special thank you for repeat attendance. The four key messages of my 1999 book can be
summarised as follows:
1 The overaccumulation of debt and the deepening addiction to debt
2 The proliferation of new credit and financial instruments
3 The increasing complexity and sophistication of financial institutions
4 The complicity of the most influential central banks in these developments
My argument today is that these same forces are re-expressing themselves in new ways to the
detriment of global financial stability. We may have better early warning systems than in 2007, more
banking capital and system liquidity, but no less vulnerability to financial crisis and economic
dislocation.
https://www.economicperspectives.co.uk/the-real-reason-real-rates-are-so...

The linked article is well worth reading..
QE was all about lowering long term interest rates.. As Central Banks start "normalizing" there is a "huge" question mark around how long term rates will react...??
The raising of long term rates might well be the trigger for the next "financial crisis"...??
towards the end of 2018 might be a time of increasing volatility..... which would mean a huge repricing of risk premiums...etc..

I have been following Peter Warburton since reading his book in 2000
https://www.amazon.com/Debt-Delusion-Peter-Warburton/dp/0713992727/ref=t...

All the models are wrong. A debt crisis leads to deflation not inflation. The money multiplier model is wrong. The fractional reserve lending model is wrong. If the models are wrong then the policy responses based on the models will also be wrong.

To me it seems that inflation targeting probably does have a place somewhere, but the average target over the medium term is probably best set at 0%.

The current targets were set as an attempt to control the rampant inflation of the seventies and eighties, with NZ leading the way by choosing 2% based on, I assume, what the US Federal Reserve thought best. The US Federal Reserve would have been chosen as having the best experts there are.

NZ could have talked to the Bundesbank and asked their advice, but at that time they would have been overwhelmed by the change to the Euro and the intricacies of retaining control of their currency during the transition. France and Britain had basically agreed to the re-unification of Germany on the basis of the creation of the Euro to tie Germany into Europe more tightly.

One way of achieving a 0% inflation rate over the medium term is to link it to real stuff. Sir Isaac Newton, presumably realising that stretchy tape measures are not much use, actually set up the monetary system that lasted Britain from 1717 through to 1931. Presumably having a reliable currency helps if you are a global trading nation and it is not by chance that this is the period of the British empire.

Newton's gold and silver standard fell apart as power moved from Britain to the US following the refusal by the the US to write off the war debts of its allies at the end of WW1. Previously the European nations usually took the view that the nations who had done more actual fighting should be let off the debts they owed to the ones who had done less, on the basis that war debts are in blood as well as treasure. This is partly why Britain and France imposed excessive war reparations on Germany.

Interestingly, the Germans also took the view that debts should never be written off when they bankrupted Southern Europe instead of rescuing the French and German banking system (ie writing off debts that cannot be repaid) like the US and UK did for their own banks.

It is not clear that a gold and silver standard is a good idea as its very rigidity gives rise to its own set of problems, but the period of the British Sterling Standard is a remarkable one as it gave us the modern world. I know it is not fashionable for us Westerners to look to our ancestors for guidance but perhaps traditional ideas have been discarded too lightly in our arrogant assumption that we know better than they. Perhaps a gold standard with an agreed method for writing off debt between nations in a timely manner is worth a look.

Inflation/OCR targeting; that hilarious sick joke where rent inflation is measured during a property asset bubble, whilst negative gearing incentivises low rents and household debt levels are not even part of the official equation whatsoever.

Inflation is also "producer inflation", copper, oil, etc. That demand won't be going away surely.

Maybe.

EU energy demand in 2035 (will be) back to where it was 50 years earlier, despite the economy being almost 150% bigger.
China adds more renewable power...... than the EU and US combined.

https://www.businessinsider.com.au/bp-us-energy-self-sufficient-in-5-yea...

Then why is Iron being touted on the open Market, cheaper than ever ....by China.

Reducing their stock pile to keep the factories producing Smoke ...and more Mirrors.....

Sorry...

That should have been.....Smog and Factories from burning their fingers.