Why does the target rate matter?
Posted April 16, 2008on:
David Farrar at Kiwiblog states that inflation outside the range is bad, and in fact our relevant target band should be 0-2%. He also states that we can act like the target is truly the point at the middle of the band – ergo we currently have a target of 2% (in the 1%-3% band). David then finishes by saying that current interest rates will have to stay high – something that will be a concern to people.
Wat Tyler (a good historical reference of a left wing blog may I add) disagrees with this way of looking at the target, states that interest rates were higher in the 90’s and so should not be such a concern, and says that a little breakout from the inflation target doesn’t matter – as long as we keep inflation in single digits.
Both sides have points – lets try to dig a little deeper and figure out what my opinion is 😉
FIrst we’ll look at the three claims of each side. First up is the inflation target – is the mid-point the same as the target band.
In this case, both sides are right. This seems weird as they are saying contridictory things, however it is a result of the fact that a “target band” is a relatively silly thing to use when we are focusing on medium-long term inflation ahead of short-term inflation (which was our initial goal, and does require a target band in order to take care of “shocks”).
David is right that the implicit target should be 2% – the 1% either way is supposed to account for random shocks to the rate of inflation. Wat is right that our current target band mechanism is not equivalent to a 2% target, just look at inflation expectations which have constantly tracked well above 2%. In a sense, the economy has seen that the inflation target is 1%-3% and it has seen that the Bank is concerned about growth etc. As a result, market expectations have moved to expecting inflation to average towards the top of the band, so close to 3%.
Next comes the interest rate call. In this case it is true that interest rates will have to stay up longer than they would if this inflation problem didn’t exist – don’t expect a mass slowdown in growth to push the RBNZ into action. Wat says that this isn’t that bad as interest rates are lower than they were in the 90’s. However, we are in a very different situation than we were in the 90’s.
Over recent years global financial trends have kept interest rates low. This has allowed New Zealand to borrow heavily from the rest of the world – which is why our current account deficit is so high. Now that global interest rates are rising again, the cost of financing this debt will be high. Note that we didn’t have as large a current account deficit back in the 90’s, which implies that even if interest rates were higher back then our level of debt with the rest of the world was lower. Given that most of this debt is private debt, the fact that interest rates are going to stay high is a fair concern to raise.
Finally we have the inflation target itself. David says set it at 1%, Wat says the target doesn’t matter too much as long as inflation remains in single figures. Now to evaluate these claims we have to look at the costs of inflation.
Higher inflation leads to more price volatility for two reasons. First, high rates of inflation are more unstable leading to varying rates of growth over time. Secondly, as Wat says, some prices are stickier than others. This stickiness can cause problems even when inflation is steady as the relative price between sticky and non-sticky items cannot be set appropriately – implying that when adjustment comes it can be more varied than required (think of it this way, if prices can only be changed at a certain date they will over-compensate the price increase based on expected inflation. If firms can’t observe whether they are having relative price changes or inflation then this timing mechanism will be sufficient to make prices jump around).
This uncertainty damages investment intentions, and creates transaction costs for cognitively limited agents such as myself 😉
Furthermore, prices are important in an economy because they help to allocate goods where they are most highly valued. If relative prices do not move effectively then we lose efficiency in the allocation of resources.
There are also other costs of inflation, such as shoe-leather costs and menu costs (see wiki 😉 ). However these costs are relatively minor in the grand scheme of things.
Now inflation becomes self-fulfilling, which is one of the main reasons why we want to avoid it. How does this work. Well if prices are rising 4%, people may expect them to rise 4% over the next year. This tells businesses that if they want to keep relative prices the same they should lift prices by 4% . Furthermore, it tells workers that if they want to keep the same spending power they have to demand a wage increase of 4%. As a result, we don’t only want to keep inflation down to avoid these costs – we also want to keep inflation down to keep these costs down in the future (see long-run phillips curve).
As a result, inflation is something it would be nice to avoid (unless we believe higher rates of inflation lead to greater levels of price flexibility – an argument I can sort of buy). This leads me to the conclusion that Wat was being a bit generous with inflation when he said it could sit in single figures, and as a result I think a target in the 1%-2% range is fine (given potential benefits of some inflation to “oil the wheels of prices” and the fact that we want to avoid any deflation passionately).
So my opinion is, either set a target band for the short run, or a target point for the medium-long term, have the target about 1%-2%. The RBNZ understands these long term costs of inflation, and is mandated to deal with it – which is why I’m confident they will leave rates elevated over the rest of the year.