Monetary Policy is Why We Don’t Have Deflation


The way Krugman’s RSS feed is set up prevents me from reading him during my normal times in the day from my phone/tablet’s RSS reader mostly because I’m lazy. Consequently, I arrive late to the party whenever he is cudgeling some poor…something or other. In any case, I just read his post on the lack of deflation:

So inflation seems “sticky”. But why? One immediate thought was that we might be looking at the effects of downward nominal wage rigidity: employers are very reluctant to engage in actual wage cuts. Way back in 1996 Akerlof, Dickens and Perry suggested that this would make inflation stubborn at low rates, breaking the usual link between high unemployment and disinflation.

The key question here is does the zero lower bound bind? In Del Negro, Eggertsson, Ferrero, and Kyotaki, the central bank still maintains control over the price level through highly effective nonstandard monetary policy even at the ZLB. However, in Krugman’s model, a large deleveraging shock pushes interest rates to zero and the central bank is unable to credibly commit to a higher inflation target:

In the context of the model, this rise in expected inflation could be accomplished by changing the Taylor rule; this would amount to the central bank adopting, at least temporarily, a higher inflation target. As is well understood, however, this would only work if the higher target is credible – that is, if agents expect the central bank to follow through with promises of higher inflation even after the deleveraging crisis has passed. Achieving such credibility isn’t easy, since central bankers normally see themselves as defenders against rather than promoters of inflation, and might reasonably be expected to revert to type at the first opportunity. So there is a time consistency problem.

It follows from this model that flexible wages increase unemployment, placing downward pressure on the price level. Indeed, in this model a freeze in nominal wages can support a positive price level. This is the result of the model featuring upward-sloping demand curves at the zero lower bound…which is itself a result of the fact that the model constrains monetary policy to interest rate rules. The key to this model’s validity is determining how great a challenge it is to overcome the time inconsistency problem. The experience of the world since 2008 (and especially the US) bears out the fact that central banks around the world are able to credibly commit to preventing prolonged deflation…though they may be too timid engineer a recovery through a higher inflation target. Yes, even the ECB counts, though ECB doesn’t seem to be interested in generating any recovery.

Unfortunately Krugman seems to be doing everything he can rescue the theory that the zero lower bound binds, thus avoiding the fact that central banks are still in control of the price level, even at the ZLB.

He even uses a head scratching example in the supposed “nominal rigidity” of first year salaries at elite law firms:

Actually, once you start looking for it, downward nominal rigidity is everywhere. For example, Catherine Rampell had a great piece pointing out that starting salaries at elite law firms have been frozen at precisely $160,000 for years:

I agree that downward nominal rigidity is extremely important in providing a transmission mechanism between changes in nominal and real variables, but surely Krugman must know that same people don’t begin working at the same law firm year after year.

Here’s the deal: in a fiat money regime, with an explicit nominal target, deflation is a choice just like any other policy choice. Even in Japan, deflation has been the choice of the central bank for the last two decades. There has never, in the history of the world, been a fiat money central bank that has tried and failed to inflate. Off and on Krugman will acknowledge this, but it’s the truth. Period, end of story.

We aren’t experiencing deflation because the Fed has decided to target a positive trend rate of inflation.

Update: Crucially, Woodford himself agrees that Japan has been successfully targeting a 0% CPI rate of inflation.

Update II: Ryan Avent notes something that was in the back of my mind while writing this piece, but didn’t make it in:

Those are important dynamics, but I’m not sure he does the most effective job explaining what actually seems to be occurring. I’d say there are three big things worth noting. The first is that we do indeed observe substantial disinflation in the absence of countercyclical policy, all across the rich world—even to the point of deflation in some cases. We see this in America, Europe, Japan, and even in “high-inflation” Britain, where annual inflation fell from just over 5% to just over 2% from 2011 to 2012. In general, it is difficult to sustain price increases when there is excess capacity in the economy, and there is indeed excess capacity across the advanced economies.

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