US rais­ing in­fla­tion tar­get won't help much now: re­searchers


The Fed­eral Re­serve could have cut short the Great Re­ces­sion by a year if it had set a 4 per­cent in­fla­tion tar­get in 1984, but rais­ing the tar­get now would prob­a­bly do lit­tle to help the econ­omy, re­searchers said. Bos­ton Fed Pres­i­dent Eric Rosen­gren and Min­neapo­lis Fed Pres­i­dent Narayana Kocher­lakota re­cently have floated rais­ing the U.S. cen­tral bank's cur­rent 2 per­cent in­fla­tion tar­get to give it more room to cut rates dur­ing eco­nomic down­turns. The idea has not gained much trac­tion in part be­cause the Fed does not want to be seen as fickle about its com­mit­ments.

In a pa­per pre­sented at the Fed's global cen­tral bank­ing con­fer­ence here, S. Bor­a­gan Aruoba of the Univer­sity of Mary­land and Frank Schorfheide of the Univer­sity of Penn­syl­va­nia showed how set­ting a 4 per­cent in­fla­tion tar­get in 1984 would have al­lowed the Fed to cut rates more sharply than it was able to do dur­ing the 20072009 fi­nan­cial cri­sis.

Un­der that sce­nario, they said "the re­turn of in­fla­tion to av­er­age lev­els is even quicker and re­cov­ery of GDP takes about a year less than un­der the his­tor­i­cal pol­icy." But they added that the ben­e­fits of rais­ing the tar­get in­fla­tion rate de­pend heav­ily on the like­li­hood of a shock push­ing the econ­omy to the point where near-zero in­ter­est rates are needed. That prob­a­bil­ity, the au­thors said, is very small: less than 0.1 per­cent in the model they used. When they ran sim­u­la­tions of the eco­nomic re­sponse to rais­ing the in­fla­tion tar­get in early 2014, they found very lit­tle ben­e­fit. "While the change in the tar­get in­fla­tion rate af­fects in­ter­est rate and in­fla­tion dy­nam­ics, the path of GDP is largely un­af­fected," the re­searchers wrote.

"Thus, this anal­y­sis sug­gests that if the cen­tral bank raises the in­fla­tion tar­get now, even if it is able to com­mu­ni­cate and con­vince the public about the cred­i­bil­ity of this new pol­icy, there does not seem to be much real ef­fects of this pol­icy change to make it de­sir­able." Aruoba and Schorfheide are known for their re­search on mon­e­tary pol­icy when in­ter­est rates are at or near zero, and their mod­els for track­ing busi­ness cy­cles and gross do­mes­tic prod­uct growth are pub­lished by the Philadelphia Fed.

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