RDP 2014-02: Fiscal Policy and the Inflation Target 1. Introduction

The US Federal Reserve has a long-run inflation target of 2 per cent (FOMC 2012). Many considerations influence this choice, but it partly reflects a trade-off: lower inflation has direct welfare benefits but it also means interest rates have a greater probability of falling to their lower bound of zero. The zero lower bound is a problem because it prevents the central bank from fighting recessions with large reductions in interest rates. So the economy would be less stable with a low inflation target. For this reason, some prominent economists, such as Blanchard, Dell'Ariccia and Mauro (2010) and Ball (2013), have argued for a higher inflation target.

Several researchers have quantified this argument. Most prominently, Reifschneider and Williams (2000) conduct stochastic simulations of the Federal Reserve's FRB/US model and conclude that the zero lower bound noticeably increases the variability of economic activity for inflation targets below 2 per cent or so. Similar studies include Coenen, Orphanides and Wieland (2004), Hunt and Laxton (2004), and Williams (2009). Billi and Kahn (2008) provide an overview. This research has played a central role in the FOMC's earlier consideration of appropriate inflation targets judging by the transcript and staff materials for the FOMC meeting of 1 February 2005 (FOMC 2005; Elmendorf et al 2005). These studies have been emphasised by policymakers such as Bernanke (2003) and Yellen (2009) in discussing their choice of inflation targets. Subsequent research by Coibion, Gorodnichenko and Wieland (2012) supports similar conclusions.

A limitation of much of the policy discussions and the underlying research is that they have assumed that fiscal policy is passive, doing little to stimulate the economy (beyond automatic stabilisers) when interest rates approach zero.^[1] That assumption was consistent with both actual fiscal policy and expert policy recommendations until recently. However, as discussed below, there has been a renewed enthusiasm for active countercyclical fiscal policy on the part of both policymakers and advisers. The key finding of this paper is that this new fiscal activism substantially reduces the frequency and severity of hitting the zero bound. By itself, that should significantly lower the inflation target, although increases in perceived macroeconomic volatility operate in the other direction.

Specifically, I develop a fiscal policy reaction function that explains recent US fiscal policy at the zero bound. I then include this rule within the FRB/US model, which is a large-scale model of the US economy maintained by the staff of the Federal Reserve Board, and run stochastic simulations. These simulations suggest that realistic countercyclical fiscal policy permits substantially lower inflation targets for a given variability of activity. For example, I estimate that a 2 per cent inflation target is consistent with a standard deviation of unemployment of 1.4 percentage points when fiscal policy is passive; but if fiscal policymakers behave as they have recently, then the same variability of unemployment could be achieved with a target of zero inflation.

In choosing an inflation target, the central bank needs to assume how fiscal policymakers and other agents will behave. My central scenario assumes that fiscal policymakers behave as they have recently. However, given the controversy over this issue, attitudes to fiscal activism might be expected to evolve. Accordingly, in Section 5, I consider two alternatives to my central scenario. It may be that the recent shift toward fiscal activism is reversed and that the passivity assumed by the earlier literature remains a good guide. If the central bank does not feel it can rely on fiscal stimulus at the zero bound, it should set a higher inflation target. Alternatively, it may be that future recessions are accompanied by larger and earlier fiscal stimulus. For example, if fiscal policy were assumed to be twice as aggressive as it has been recently, then my simulations suggest that the zero bound would cease to be an important constraint on the inflation target.

The idea that fiscal activism might lower the inflation target is not new. For example, it is discussed by Reifschneider and Williams (2000), among others. However, this effect has not been realistically modelled and its effects have not been quantified or shown to be important. That may be why policy discussions and research have overlooked it. To put this in context, Yellen (2009), Blanchard et al (2010), and others have emphasised the implications of changes in perceived macroeconomic volatility for the target. However, estimates I present below suggest that the change in fiscal policy is of similar importance for the inflation target as the change in volatility.

The previous analysis that comes closest to mine is Williams (2009, section III.B). As in this paper, Williams conducts stochastic simulations of FRB/US with different inflation targets, with and without countercyclical fiscal policy. However, Williams' interest is in whether fiscal stimulus might ameliorate worst-case scenarios: he applies it to a baseline in which the funds rate is at zero 34 per cent of the time (with a 2 per cent inflation target). In contrast, I focus on scenarios that resemble mainstream projections of the US economy. Furthermore, Williams' fiscal rule is illustrative rather than realistic. I develop a rule that is consistent with observed policy. Williams is frank about the limitations of his rule and calls for further research in this area. This paper is partly a response to that demand.

A secondary contribution of this paper is to develop an empirically-based reaction function that describes how US fiscal policy behaves near the zero bound. This may facilitate discussions of fiscal policy near the zero bound in the way the Taylor rule has done for monetary policy. Calibrating this rule to actual policy is important because one of the primary objections to the use of countercyclical fiscal policy has been that lags make it impractical (Blinder 2006). To be clear, precise estimation is not the goal, and would not be feasible. Rather, my rule is intended to roughly capture the size, timing and impact of the recent stimulus, which seems sufficient to assess the relative importance of various factors in different conditions.

Although the titles might suggest otherwise, this paper has little in common with the literature surveyed by Schmitt-Grohé and Uribe (2010) on ‘the optimal rate of inflation’. Whereas in this paper the zero bound is of central importance to the inflation target, the research surveyed by Schmitt-Grohé and Uribe assumes that the zero bound is irrelevant. Schmitt-Grohé and Uribe justify this assumption by arguing that under optimal monetary policy the probability of hitting the zero bound is very low. However, the recent history of interest rates in the United States, Japan and other countries suggests that under actual monetary policy, the chances of hitting the zero bound are considerable.

To be clear, this paper is not intended to evaluate alternative policies for dealing with the zero bound. That issue has been addressed elsewhere by many authors, including Eggertsson and Woodford (2006), and Mankiw and Weinzierl (2011). Rather, I take actual monetary policy, as described by a conventional policy reaction function, as given. And I use a fiscal policy reaction function that describes recent behaviour. This paper examines the implications of these reaction functions for economic stability and the inflation target. Normative analysis of fiscal policy near the zero bound, including its size, timing and composition, would be highly desirable. However, a positive analysis of recent policy behaviour seems a desirable stepping stone and benchmark for that.

Similarly, this paper does not examine implications of recent innovations in monetary policy, such as asset purchases. The rationale for considering new developments in monetary policy is similar to that for considering new developments in fiscal policy, and the implications for the inflation target are qualitatively similar. I expect including asset purchases as an extra instrument of monetary policy would further allay concern about the zero bound, reinforcing one of my key results. But, at this stage, that conjecture remains to be verified.

Footnote

I use the terms ‘active’ and ‘passive’ in their everyday sense of responsiveness to economic activity. This usage differs from Leeper's (1991) well-known definitions in which fiscal policy is ‘active’ or ‘passive’ depending on whether it stabilises the debt. [1]