by Andreas Hoffmann*
The Wall Street Journal Online recently quoted an IMF paper (written by Oliver Blanchard), that a higher inflation may help to give leeway to monetary policy in times of crisis. What is this about?
Blanchard argues that if inflation rates are targeted at 4 percent rather than 2 percent, this would not make much difference. Following Blanchard, the ‘2 percent target’ is chosen ad hoc. Further, two additional percentage points of inflation would not do any/much damage (by e.g. increasing the volatility of an economy). On the other hand, as inflation adds to nominal interest rates, these would increase with higher inflation. Thus, the room for interest rate cuts will be larger potentially to stimulate the economy in times of crisis.
This sounds seductive. I have four comments:
(1) Blanchard is probably right when he argues that 2 or 4 percent would not matter much. But it is a target. Targets may be missed. The higher the target, the higher the probability of increased volatility. Or as Taylor asks in the article above: “If you say it’s 4%, why not 5% or 6%?”
(2) The investment function is not a function of the nominal rate, but of the real rate. Because I am sure that Blanchard did not forget about this, it brings me to –
(3) Cutting nominal rates (incl. 4 percent inflation) from 6 to 2 percent would result in negative real rates of 2 percent since prices would be stable for a while. Just as the current monetary policy this would allow for all kinds of investment projects with even negative returns. The inter-banking market would break down. Why would you lend someone money at risk when you profit from lending it at no risk. This should reinforce the deflationary tendencies of the crisis. Where is the improvement?
(4) Nominal interest rates did not decline because inflation declined over the last decade. Inflation was relatively stable. The leeway is gone because real interest rates have been cut strongly in times of crisis, but have been raised to a lesser extent in the following boom periods.
Therefore, in my opinion, real rates have to be raised and lowered more nearly symmetrically in boom and bust periods. This would give leeway to monetary policy makers in times of crisis.
*Andreas Hoffmann is visiting the Department of Economics, New York University from the Institute for Economic Policy, University of Leipzig during the current academic year. He is a Bradley Fellow and a Fellow of the Friedrich Naumann Foundation. Some of his work can be found here.