RDP 2014-02: Fiscal Policy and the Inflation Target 6. Lessons of the Crisis

The previous section suggested that researchers and policymakers may have overestimated the optimal inflation target by neglecting countercyclical fiscal policy. However, that is not the only lesson from the recent crisis. We have also learned, for example, that macroeconomic shocks are more volatile. Yellen (2009), Williams (2009), and Blanchard et al (2010) have discussed having a higher inflation target because of this increase in perceived volatility. This raises the question of how changes in fiscal activism and volatility should be balanced against each other. Put another way, suppose a policymaker regarded an inflation target of say 1.5 per cent as appropriate before the recent recession (as suggested by Elmendorf et al (2005) or Yellen (2006), among others). Given what has been learned since then, what might be his or her new target?

Figure 5 provides one possible answer. The blue and green lines represent the trade-offs between inflation and instability reproduced from Figure 4, labelled as before. To illustrate how a central banker in early 2007 might have perceived the trade-off, the line labelled ‘as of 2007’ is constructed assuming passive fiscal policy and drawing residuals from the period 1968 to 2006. That curve is essentially the same as the estimates of Reifschneider and Williams, adjusting for measurement differences.[10] This is intended to be a simple approximation to the menu from which policymakers may have chosen a target of 1.5 per cent.

Figure 5: Different Trade-offs between Inflation and Unemployment Instability

The curve drawn through point A reflects a hypothetical indifference curve. The preferences that might give rise to a choice like A can be represented by the loss function:

where π* is the inflation target (not deviations from the target, as often appears in discussion of stabilisation policy), the parameter 0.5 is Elmendorf et al 's (2005) estimate of the measurement bias in the PCE price series, σ is the standard deviation of the unemployment rate, and the coefficient 22 is chosen so as to minimise the loss at point A. For simplicity, I assume that other factors that affect preferences over inflation objectives, such as tax distortions or downward nominal wage rigidity, are roughly offsetting. At point A, the central banker has an inflation target of 1.5 per cent, which implies a standard deviation of the unemployment rate of 1.10 percentage points. Such a choice implies that an extra percentage point of steady-state inflation is worth 0.04 percentage points extra standard deviation of unemployment. Indifference curves through points B, C, and D represent the same preferences.

Under these assumptions, a central banker who perceives that volatility has increased, but that fiscal policy will remain passive, might choose a point such as B, with an inflation target of 2 per cent. The difference between points A and B illustrates the sensitivity of this approach to changes in estimates of volatility.

Were the central banker also to believe that recent fiscal stimulus is likely to be repeated, he or she may choose a point like C, also with a target of 1½ per cent. According to the model's estimates, the inflation target is about the same as the pre-recession choice, because the change in fiscal policy offsets the increase in perceived volatility. Thus, although changes in volatility are important for the choice of inflation target, whether fiscal policy is active or passive is of similar importance.

If fiscal policy were even more aggressive, the inflation target could be lower still. For example, a fiscal policy that is twice as aggressive as recently would imply point D, with an inflation target of 0.9 per cent. For such an aggressive fiscal policy, the trade-off between steady-state inflation and instability is very flat. In these conditions, the inflation target is essentially decided by considerations other than the zero bound, such as estimates of measurement bias.

The examples above are illustrative and omit some other important lessons from the recent crisis. For example, we have also learned that central banks are likely to purchase long-term securities so as to reduce bond premiums. Furthermore, point A may not be the best starting point, as suggested by Billi (2011) or Coibion et al (2012). But notwithstanding these caveats, the simulations shown in Figure 5 suggest that the inflation target should not increase simply because perceived volatility has increased.


See their presentation to the FOMC on 29 January 2002 (FOMC 2002). My estimates are about the same as those in row 2 of the middle panel on page 161 if the inflation rate is shifted by half a percentage point, the average difference between CPI inflation and PCE inflation. [10]