Slow-moving changes in equilibrium real rates could be accommodated with periodic inflation target reviews by an independent 3rd party

Many, for different reasons, have suggested that the rate at which central bank policy rates might settle will be significantly lower than the rate that prevailed on average in the pre-financial crisis period. In his parting speech as Deputy Governor for Monetary Policy, Charles Bean suggested that rates might end up around 3 per cent, at least 2 percentage points lower than they were before.

Such a large change would warrant an upward revision of the inflation target.  Without it, there would be insufficient room to use central bank rates to control inflation and cushion the real side of the economy from the effect of shocks as they come along.   This is so because, in the absence of these shocks, the central bank rate will settle at a rate that is equal to the real compensation people demand for lending money and not consuming now [leaving risk out of it] plus the extra they need to protect their investment against the erosion in purchasing power caused by inflation. [In models the equation that delivers this is known as the Fisher equation].

There would have been a solid case for an upward revision in inflation targets even in the absence of lower long term real rates.  Before the recent financial crisis, the probability of hitting the zero bound to interest rates in developed economies was judged inside central banks to be extremely small, and the chance of experiencing a protracted period trapped there as vanishingly so.  (The view in officialdom was, so far as I could tell, that the travails of the Bank of Japan, trapped at the zero bound for more than 15 years before our crisis, was down to a special set of institutional failures and incompetence in the Ministry of Finance, the BoJ, and corporate governance.  How wrong that turned out to be!).   So, if we add in the central guess at the change in equilibrium real rates real rates, it could be argued that the inflation rate should rise by around 3 percentage points.

The forces that determine long-term real rates, and hence the amount of room above the zero lower bound for a given inflation target, are presumably likely to wax and wane. So in an ideal world one would have the inflation target moving all the time as a function of estimates of this equilibrium real interest rate.  Such a system would probably be chaotic and open to abuse.   A practical approximation to the ideal might be low-frequency reviews, say every five to ten years.

If such reviews were to happen, who would carry them out? In the UK, currently, the Finance Minister [aka Chancellor of the Exchequer] has the power to set this inflation target whenever he or she likes.   So in principle, incorporating that inflation targets are set as a function of real rates could be done without any institutional reform. However, the custom of such targets has been that they are set for good, bar on a trajectory for disinflation, or major redefinitions of the price index. My guess is that if the Government were to start changing the target to accommodate real rate changes the UK monetary framework would fall into disrepute, and that the view of those at the top of officialdom would be that any accommodation of this kind should be avoided for this reason. After all, there are many at the top who can still remember the bad old days of UK monetary policy and were presumably burned by the experience.

However, if no changes were made and we were in for a ten-year period of very low real interest rates, not adjusting the inflation target might be risky for the legitimacy and therefore the credibility of monetary policy too.   (Legitimacy:  why should we have an institution that doesn't do what's right for us?  Credibility:  why should we believe that an institution will follow through on something that isn't in anyones' interest?).  In the darkest days of the last recession, before the Bank of England persuaded everyone of its Panglossian view of the effectiveness of QE, it was easy to imagine that the political consensus for low inflation would evaporate, along with other components of current capitalist practice. Doing what was necessary to avoid another period trapped at the zero lower bound could actually be the best thing the authorities could do to nurture society’s confidence that monetary policy was in sound hands.

A solution might be that inflation target reviews were carried out by some 3rd party, call it an Inflation Remit Review Commission. Such a third party being not the Government, which might be suspected of engaging in financial repression under the guise of a benign response to secular stagnation. And also not the central bank which, at least in the UK,  already has an alarmingly large set of jobs to do, and should not be put in the awkward position of being seen to set the targets against which its monetary policy performance will be judged.

One objection to this proposal might be: haven’t we discovered that we can do quantitative and credit easing, and therefore freed ourselves of the constraints of the zero bound? If you believed all the Bank of England wrote (at least before the moratorium on QE that coincided with Mark Carney’s chairmanship of the UK’s monetary policy committee), this is what you might conclude. However, in reply to this many things can be said. First, many  don’t subscribe to the view that QE worked.  Summarising previous posts on this which outlined this view: i) it has not been proven that the effect of QE on yields was persistent or simply due to signalling about future rates; ii) whatever effect on yields was achieved does not necessarily translate into a benefit; iii) all the major central banks clearly felt there were political or other costs associated with QE at some point, in which case it cannot be considered to relax the constraints of the zero lower bound altogether.  Credit easing seems much more desirable and effective to me, but also hardly a perfect substitute for the much better understood tool of interest rates.

Another objection might be that we could hope for institutional reform to fiscal policy so that conventional spending and tax instruments could be brought into play to back up monetary policy, or even replace it, if a zero bound episode loomed. Simon Wren Lewis and Jonathan Portes argued recently for such reforms.  Such reforms would be desirable but there is no immediate prospect of them.  Delegating these tools might be thought one delegation too far, and never happen in our democracies. Moreover, the reasons why central banks assumed the job of macroeconomic stabilisation with the use of monetary policy still hold – that using discretionary fiscal tools is unwieldy and generates costs of its own.

Some might object that the experience of the financial crisis in giving birth to sounder regulation and macro-prudential tools should mean that we don't again encounter the zero bound.  This objection is the weakest of all in my view.  Regulation is perceptibly more conservative, but still complicated, confusing, and unresolved.  Macroprudential tools and the institutions wielding them are untested.  The recent crisis underscores to me that the experience is to be repeated more often than we thought before it, not less.

The device of the 3rd party review would mean the Government foregoing its current perogative to change the target at will, a very British and anachronistic piece of institutional discretion.  And a Review could handle future redefinitions of the price index, allowing genuine changes on technical grounds to be seen as such, protecting the Government from accusations of financial or monetary policy engineering.  It might also tackle the issue of how the central bank should weigh the competing goals of inflation and real economy stabilisation, (and, in fact, also the meta-issue of whether this should be a matter for the central bank itself or not).