What Does Inflation Targeting Fifty-Fifty Mean?

My before article on cost indices -- The Price Level Does Not Exist -- was tentative, together with needed a to a greater extent than detailed explanation of my thinking. This article is an endeavor to give a to a greater extent than detailed background, together with I am tying it to inflation targeting. It should hold upward noted that this is non merely a jab at mainstream economics, it also applies to some post-Keynesian thinking. For example, i mightiness summarise the policy goals of Modern Monetary Theory (MMT) every bit "full occupation alongside cost stability" -- which is somewhat awkward if nosotros cannot define a cost grade that is supposed to hold upward stable. (This observation nearly MMT came to me during the recent MMT conference, together with the article reflected my on-the-spot thinking.)

Long History Of Attacks On Price Indices

The job alongside the snappy championship of my previous article is that it blunders into a fairly ancient laid of contestation inwards economical theory. I knew this, but I could non longer recollect who wrote what nearly the topic. I noted that I am non attempting to write an academic article, together with I did cite the most corrosive attacks on the existence of a cost grade past times the Austrian economists.

Luckily, I receive got well-informed readers, together with they did some of the requisite literature survey for me. (Thanks!) I would highlight the article past times Nathan Tankus, "Are General Price Level Indices Theoretically Coherent" (spoiler: no) which fills out the historical background of my critique from a Keynesian viewpoint. His comments on modern policy comments reverberate my thinking:

This is a good known laid of issues; yet strangely heterodox economists receive got non actually taken it up. You tin nonetheless reveal enough of heterodox economists uncritically speaking of “inflation”. H5N1 fruitful avenue of hereafter enquiry would hold upward reorganizing information to hold upward coherent from a heterodox economic science yell for of view. From hither nosotros tin enquire what dissimilar policy implications would heterodox economists derive from multiple cost indices, including multiple indices of property prices?

Naïve Theoretical View

The perspective I was writing from was that I normally take, starting from the theoretical hodge-podge that is financial marketplace position economics. (It may audio "mainstream," but I uncertainty that whatever mainstream academics desire to convey the blame for the marketplace position economical framework.) The mutual sense mental attitude i would convey is this: "Sure, the Keynesians/Austrians came upward alongside these theories decades agone proverb that nosotros cannot role cost indices, but nosotros role them all of the time. What's upward alongside that?"

This is yet some other expanse where the mainstream completely ignores heterodox critiques, together with only mortal alongside a noesis of the history of economical thought would know what the mainstream response is. Since I receive got no thought what justification the mainstream uses to justify the role of unitary cost indices, I am merely going to facial expression at the job from a starting yell for that is close to where the mainstream is, together with illustrate the number for the reader using familiar terms.

Modelling the 1970s

Imagine that nosotros are edifice a elementary economical model that captures the sense of most developed economies inwards the 1970s. The model is aimed to hold upward largely aimed at the domestic economy, so it volition hold upward an (almost) closed economic scheme model. (I am ignoring the existent issues that European countries had alongside their currency regimes.) I am non attempting to depict the entire model, only the model variables that refer to inflation.

• The start variable is the cost of oil, which nosotros volition assume is largely laid inwards basis markets, that is, external to the model of the domestic economy. (The U.S. is an extremely large consumer of oil, together with thus it mattered on the demand side. That said,  the OPEC cartel did receive got a express powerfulness to stick the cost of crude oil where it wanted.)
• We volition assume that nosotros tin aggregate all payoff inwards the domestic economic scheme into a unmarried variable (which matches the park assumption). Since nosotros volition assume that this model is either monthly or quarterly, the reality is that this serial should react to most economical variables relatively piece of cake (since wage agreements typically receive got a bridge of a year). Since at that spot was a fair amount of indexation of payoff inwards that period, at that spot would hold upward a constituent of payoff that volition react mechanically to the (historical) evolution of the model's aggregate consumer prices. As I hash out below, the supposition that nosotros tin do this aggregation is heroic.
• We volition assume that domestic non-energy retail prices are largely determined past times a markup over the wage bill, which matches the reality of how almost all retail prices are set. There may hold upward a small-scale mechanical leakage of release energy prices into these domestic prices.
• If nosotros do model imports, nosotros volition assume that unusual exporters are cost takers, together with thus weather condition inwards unusual economies volition receive got no lawsuit on non-energy prices.
• The model's aggregate consumer cost index is constructed inwards the park fashion, aggregating the release energy together with non-energy retail prices.

To recap, at that spot are 3 underlying variables associated alongside prices.

1. Energy prices (determined exterior the model).
2. Domestic wages.
3. Domestic non-energy retail prices. (This corresponds to "core CPI" inwards this model.)

(There is a derived variable -- the domestic retail cost grade -- that is determined past times non-energy retail together with release energy prices using an index formula.)

This setup is non greatly dissimilar than that of most mainstream macro models. For now, the only apparent departure of annotation is that release energy prices receive got shown up, together with the linguistic communication around cost markups may stupor hardcore believers inwards full general equilibrium.

If you lot are a believer inwards the importance of expectations inwards the conclusion of the cost level, I would yell for out that they would demo upward inwards how markups are determined past times businesses. Even inwards the 1970s, businesses by together with large avoided constant cost changes (the exceptions would things similar retail gasoline, which is showing upward inwards the release energy cost constituent of this hypothetical model). They would thence laid electrical flow prices inwards a fashion that incorporates the expected charge per unit of measurement of inflation of their input costs.

The departure betwixt my description of these variables together with touchstone mainstream models is that they are vague nearly how prices are determined ("equilibrium"), together with they largely assume away the concern sector's costless volition inwards determining markups. In the mainstream story, markups are determined mechanically past times marginal productivity, together with thus nosotros tin essentially eliminate either payoff or domestic prices from the model dynamics. They direct to eliminate wages, together with so nosotros terminate upward alongside the familiar story that everything revolves around the aggregate consumer cost index.  

What happens inwards this hypothetical model when nosotros attempt to imitate the 1970s? We would desire to catch how the model economic scheme reacts to an upward spike inwards the cost of energy. The interesting business office of the model dynamics -- which is dissimilar than the electrical flow surround -- is that wage indexation volition enhance the domestic wage index. Unless businesses are willing to absorb this inwards their turn a profit margins, domestic non-energy prices larn marked up. Depending on what behavioural assumptions nosotros stick into the model, this should supply a fertile basis for an inflationary outcome.

Ugly Implications

Even this elementary framework -- which is extremely closed to what is used inwards conventional economical models -- it is hard to catch what inflation targeting means. What is the key depository financial establishment supposed to hold upward targeting? The overall consumer cost index? Ex-energy ("core") consumer prices? Domestic wages?

Nobody serious believes that key banks (possibly excluding the i for Saudi Arabia...) tin laid the grade of release energy prices. We tin attempt to label a ascent inwards release energy prices "a relative cost shock" (I am fairly certain I receive got written that myself), but a factor of 10 increase inwards crude oil prices goes beyond that. Until nosotros receive got some sense alongside such shocks, nosotros receive got no thought how much this crude oil cost ascent volition mechanically feed into the overall retail cost level. (We mightiness receive got such omniscience inwards a model, but that is non a realistic characteristic that nosotros tin base of operations policy on.)

We tin attempt looking at ex-energy prices, which appears to hold upward the consensus sentiment (outside of the European Central Bank, which was proud to hike rates inwards 2008 inwards response to the crude oil cost spike). However, I believe that this strategy was evident inwards the 1970s, where all sorts of prices were beingness excluded from consideration due to "special factors." (Anchovy prices were a large deal.) If nosotros build cost indices to exclude all of the things that are going up, nosotros tend to immature adult woman inflationary events (which in all probability explains the ECB's mental attitude inwards 2008).

Furthermore, a lot of "core" prices are things that key depository financial establishment policy tin do footling about. In recent years, the major drivers of nub inflation receive got been tuition together with medical prices -- which are prices laid inwards markets that are far removed from the mainstream ideal of competitive equilibrium. We so encounter the query of needing to split upward retail prices into cyclically sensitive components, together with those that are insensitive (e.g., medical together with instruction components of the CPI).

Finally, nosotros terminate upward alongside the solution that is closest to practice: the key depository financial establishment de facto targets the full general wage level. This is in all probability the only variable that monetary policy (or financial policy) tin promise to influence.

Why do nosotros receive got key banks targeting consumer cost inflation, together with non wages? Politics seems to hold upward the only answer. It's a lot to a greater extent than acceptable for the key depository financial establishment to state that it is trying to maintain downwards the prices you lot (the voter) pay than it to tell you lot the truth -- it does non desire your payoff going upward to quickly. It also appears gives the key depository financial establishment a costless top on the whole query of the partitioning of income into shares betwixt upper-case missive of the alphabet together with labour.

This political expediency in all probability explains why state that key banks are targeting something they actually cannot direct influence, together with nosotros terminate upward alongside muddled models.

One interesting yell for to maintain inwards heed that i of the major selling points of modern mainstream macro (e.g., DSGE models) was that they could explicate the 1970s inflation. However, these models would receive got a real hard fourth dimension trying to bargain alongside the moving parts of my minimally realistic model setup, alongside the 3 cost components.

It Gets Worse...

One mightiness fence that I receive got actually only added crude oil prices (since everyone knows that markups are solely determined past times marginal productivity). However, the minimal model ready described inwards a higher house was also simplistic.

It is non hard to catch that the jobs marketplace position is non homogeneous. At the minimum, at that spot is a split betwixt skilled together with unskilled workers (with the Definition of "skilled" beingness "background that fits employer science demands exactly"). As the well-known inequality studies receive got shown, wage growth is non uniform betwixt these groups.

In "Policy together with Poverty" Hyman Minsky discussed the effects of such a split using a model past times Baumol. (Reprinted inwards Ending Poverty: Jobs, Not Welfare.) It should hold upward noted that Minsky observed the inflationary effects of the quondam Keynesian policies inwards existent time, together with attributed them to this split inwards the labour market.

Even splitting the labour marketplace position inwards ii causes modern mainstream macro to intermission down. Economic agents are somehow supposed to receive got expectations for all economical variables on an interplanetary space fourth dimension horizon, together with these expectations are to hold upward brought into equilibrium. The key supposition is that every solid is the same. When nosotros split the labour marketplace position into two, how just is that supposition going to work?

Furthermore, nosotros catch that wage growth differentials betwixt groups are persistent; hot sectors or regions typically move on to run hot. How tin the key depository financial establishment handle expectations nearly average wage growth, if no sector is growing at the aggregate average?

Anyone attempting to micromanage inflation is inwards a fog. Different sectors receive got differing levels of productivity; at what yell for are wage gains unacceptably high?

Backwards-Looking Inflation Targeting

This job is largely untenable. However, inflation targeting tin operate -- so long every bit nosotros ignore mainstream economical theory. All nosotros necessitate is a key depository financial establishment that reacts to historical aggregate cost data. If realised inflation numbers are "too high," it merely hikes rates until it causes a recession. We merely necessitate to rely on the historical vogue for recessions to drive downwards prices across the board, together with nosotros do non actually necessitate to know what is happening at the sector level.

This makes inflation targeting facial expression less politically palatable. Does it brand sense to stimulate a recession if consumer cost inflation creeps upward to 3%? Central banks necessitate the political comprehend of pretending to painlessly micromanage expectations, together with non state what they are actually doing.

Concluding Remarks

If nosotros cannot rely on aggregate cost indices, how policy tin interact alongside "inflation" is non especially clear.

(c) Brian Romanchuk 2017