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Thursday, September 15, 2016

Fiscal consequences of shifting an inflation target from 2% to 4%

by Ajay Shah.

Most advanced economies have a nominal anchor for monetary policy in the form of an inflation target at 2%. This has presented difficulties when the policy rate hits 0%. This calls for using a new and more unpredictable tool -- quantitative easing -- or finding ways to force the short rate below zero. Both are difficult.

Some people are proposing that the inflation target should be raised to 4%. This possibility is being posed as a choice between two unpleasant things. On one hand, the smooth working of the economy will be impeded by higher inflation, but on the other hand we have to deal with the zero interest rate lower bound. Ben Bernanke's recent blog article is an example of this debate.

In addition to these arguments, there is a fiscal perspective that needs to be brought on the table.

Suppose we suddenly raise the inflation target from 2% to 4%. Suppose there is no disruption, everything works out smoothly. In the ideal scenario, the yield curve should parallel shift up by 200 bps at all maturities.

This would be bad news for persons holding nominal bonds issued by the government, persons holding nominal pensions, nominal bonds issued by private corporations, etc.

A person who has a nominal pension backed by a corporation will be angry about it. But there will be nothing she can do about it. Persons who hold claims upon the government would not accept these losses lying down. They would organise themselves politically and ask for compensation for the losses they would face if such a decision were taken.

How large are the magnitudes? Suppose a country has explicit nominal government bonds and implicit nominal pension debt adding up to 100% of GDP. Suppose this has an average maturity of 10 years. The 200 bps parallel shift of the yield curve would impose a loss of 20% which works out to 20% of GDP. There is no democracy in which monetary policy wonks are going to be able to impose a cost of 20% of GDP upon some people without a political fight. A negotiation would take place where the adversely affected persons will ask for compensation.

This negotiation will be a difficult one. As an example, envision the US Treasury, the US Fed, and bondholders sitting in a room arguing about 20% of GDP. Things become more difficult in countries where the government owes nominal defined benefit pensions.

If the negotiation works out smooth and clean, the debt/GDP of the country goes up by 20 percentage points. This will make bondholders and credit rating agencies more nervous about the fiscal solvency of the country. While some countries (e.g. Australia) have good fiscal health, most advanced economies do not.

The last and most troublesome issue is that of credibility and confidence. Many advanced economies have a difficult fiscal situation, particularly when off-balance-sheet liabilities are counted. The bond market has generally been quite well disposed towards these countries; e.g. the bond market assumes the US will solve its fiscal crisis, even though nobody can see how this would be done. One key element of this confidence on the part of the bond market is: trust in the 2% inflation target. As fiat money is anchored with a 2% inflation target, the fiscal authority cannot inflate away debt by using inflation surprises. This reassures bond holders who are then willing to lend money to the sovereign at low interest rates.

Suppose the negotiations associated with the increase in the inflation target don't work out well. Some bondholders walk away feeling they were unfairly forced to accept a loss. There will be less trust the next time around. The bond market will not trust the 4% inflation target in the way it has come to trust the 2% inflation target. It will demand a risk premium in exchange for bearing the risk that the institutional mechanism of monetary policy is not trusted for decades and decades to come.

For some advanced economies, under certain kinds of mishandled negotiations, the project of trying to raise the inflation target from 2% to 4% could lead to a sharp one-time increase in the debt/GDP ratio and a higher required interest rate for government debt. These two outcomes could significantly worsen the fiscal situation for the government.

These considerations should be brought into the picture when evaluating the costs and benefits of raising the inflation target from 2% to 4%.

On related issues, this article from June 2009 has worked out reasonably well. One change that intervened was that the US moved closer to formal inflation targeting in 2012, thus removing some of the concern.

I acknowledge useful discussions with Josh Felman on these issues.

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