After an under-shoot, policymakers are meant to bring inflation back to target
Symmetry is the latest buzzword in central banking. In Europe, the US and Japan, inflation has consistently undershot the target that central banks are obliged to achieve. Consequently, many economists claim that central bankers should be comfortable allowing inflation to overshoot if they treat their mandates symmetrically. The minutes of the latest Federal Open Market Committee meeting suggest that the Fed agrees: “A temporary period of inflation modestly above 2 per cent would be consistent with the committee’s symmetric inflation objective.”
The symmetry strategy sounds sensible: why shouldn’t seven years of inflationary feast follow seven years of deflationary famine?
Symmetry has a very specific meaning in this context. It describes how central bankers think about the cost to society when inflation deviates from the target. Symmetry implies that this cost only depends on how far inflation deviates from the target and not in which direction.
The “feast should follow famine” argument contradicts this definition. After a prolonged undershoot policymakers are supposed to bring inflation back to target and no more. Deflationary bygones are bygones. Symmetry argues against overshooting and is not a justification for looking the other way when fiscal stimulus drives inflation above the target.
Macroeconomics puts a lot of emphasis on expectations of the future in driving outcomes today, and inflation is no different. Expectations could be influenced by recent experience, so a prolonged period of low inflation might cause inflation expectations to uncouple from the target. You could therefore justify a temporary overshoot within a symmetric framework in order to drag those expectations back up to the target. But once expectations have re-aligned, then inflation must be brought back to the target.
“Allowing the economy to ‘run hot’ could reverse some of the damage caused by the financial crisis.”
An alternative, somewhat speculative, argument for letting inflation over-shoot is that it will help to heal the scars caused by the global financial crisis. The period of weak activity that followed the crisis probably damaged the productive capacity of the economy. It is possible that allowing the economy to “run hot” in the future could reverse some of that damage — for example, by tempting discouraged workers back into the labour force.
There are two arguments for over-shooting based on specific circumstances: when you are particularly concerned about the tail risk of very low inflation outcomes; and when an economy is mired in deflation and the central bank has run out of conventional tools to stimulate it.
- The first argument involves compensating for the tail risk of far too little inflation by aiming for a little too much so that, on average, you expect to hit your target. This strategy can lead to modest overshoots, but only so long as the tail risk remains a pressing concern.
- The second argument involves nothing less than a temporary suspension of the inflation targeting framework, with the central bank making a commitment to target a rising price level. Now the central bank is obliged to compensate for too little inflation today by engineering too much inflation tomorrow.
These arguments explain why the Bank of Japan has committed to over-shooting its target. It is close to having exhausted conventional stimulus measures. But it is unclear how these arguments apply in, say, the US.
This strategy of talking symmetrically but acting asymmetrically raises awkward questions about accountability and transparency. If policymakers are trying to re-anchor inflation expectations, or even implicitly targeting a price level, then they need to say so. And they need to explain how they intend to correct the inflation overshoot. Appealing to symmetry is not enough.
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