Inflation as Insurance

It is common to hear, in the best arguments against a higher inflation target, that the costs outweigh the benefits. For a representative example, Coibion, Gorodnichenko, and Wieland argue that within a New Keynesian model, the distortions higher steady-state inflation creates among the relative prices of goods and services are high – exceeding the benefit of avoiding a liquidity trap in the future. I don’t have much in the way of technical expertise to critique this model, though I am skeptical of the calibration – they assume that the frequency with which we will hit the zero bound in the future may be extrapolated from historical tendency. However, if the Wicksellian interest rate is on average lower now than in the past, this calibration would be optimistic.

But that is beside the point. Let’s assume that the costs of inflation outweigh the benefits.

How would you react if someone advised against purchasing health insurance because the cost outweighs the expected benefits. Many people pay heavy monthly premiums to avoid calamity in the event of a worst-case event. There are many models you can use to justify this insurance. Maybe costs are not linear. That is, the closer one gets to the bottom of his bank account, the more utility the marginal dollar brings. So long as the premium itself is not forcing him to dissave, it is not hard to imagine the value of insurance. Perhaps uncertainty itself is costly. This is a well-established behavioral phenomenon. Go ask a stranger whether he wants $500 in cash or $1,500 if he wins a coin flip.

A liquidity trap is not perfectly analogous, but it’s not hard to see its similarity with a heart attack. While there is debate among some as to whether the zero bound binds – Bernanke in his academic research is a great example – the performance of Western economies in wake of the crisis, not to mention Japan over the past decade, suggests monetary policymakers either lack the will, knowhow, or confidence to implement such policies.

Instead we get risky and untested asset purchase programs as well as forward guidance which suffers from time inconsistency and relies heavily on the credibility of a decentralized institution. We get political dysfunction and immobility. The Tea Party and Occupy Movements are at least second cousins of the liquidity trap – enough political science research suggests a bad economy engenders extremism.

My point here is that including political and social costs of mass unemployment, it is not enough to say the costs of inflation outweigh the benefits. The Fed understands this, to some extent, considering its heroic effort to stimulate the economy with unconventional tools. But even assuming they worked perfectly, is the cost of removing high quality collateral from the financial system worth the benefit of a slightly lower inflation rate?

This whole post is a contingency. I don’t think the costs of inflation outweigh the benefits, but I can’t construct a fancy model to prove that. It is worth asking why we target a lowly 2% to begin with. Because New Zealand did it?