Happy weekend! Here are some links to things I've been reading or watching that you might also enjoy:
1. My new podcast conversation, with former IMF chief economist and Governor of the Reserve Bank of India, Raghuram Rajan. We recorded this at the University of Chicago's Booth School of Business, where Rajan is a Professor of Finance. At the bottom of this email, I've included five excerpts.
2. 'First malaria vaccine slashes early childhood mortality', from Science.
3. 'Stamina Succeeds', a blog post by Robin Hanson.
5. 'A Brief Disagreement', an animated short by Steve Cutts.
Have a great weekend,
Excerpts from my podcast with Raghuram Rajan
1. How was the commonly-used 2% inflation target derived, and how are inflation expectations actually formed?
WALKER: Some questions about the history of inflation-targeting. As you know, the Reserve Bank of New Zealand was the first central bank to adopt an explicit inflation target, in 1990. It picked 2%, and then soon after, all the major central banks followed suit. Why have all the major central banks coalesced around this 2% number? How was it derived?
RAJAN: I think just like the Basel capital requirements initially – which was set at, if I recall, 8% – out of thin air. It seemed like a reasonable thing; not too close to zero, and not too high up that at some point inflation becomes noticeable. Two per cent is a level where you get some inflation, but nobody really cares about it. Studies of where inflation becomes a problem typically would say somewhere in the double digits. So there’s a lot of room between 2[%] and double digits. And the reality is, the worry is, when inflation is higher, it can start getting a life of its own. And so what you want is a level of inflation which is low enough that nobody really cares too much about it. Then what that does is it means that things get anchored around that. And there are relative price movements, but not an absolute price movement.
It’s at the higher levels that the relative price movements become more absolute price movements and you get more generalised inflation from, say, the oil price going up, stuff like that.
WALKER: And I suppose there may also be some kind of psychological effect of double digits?
RAJAN: I’d say high 8, 9% is also a reasonably high level of inflation. And remember, it’s an average. So things could be going up 15, 20[%]and say, “Oh my God, my shoes have gone up so much!” As you know, people’s thinking about inflation is never driven by the CPI; it’s driven by the salient stuff that you see, right? “What do I think is most important,” and that’s going to drive your perceptions.
WALKER: Yeah, well, I have a question on that. It’s a small question: what’s your best explanation for how inflation expectations are actually formed?
RAJAN: It’s a great question, because I always wondered how, certainly in India, because our whole edifice of inflation control is built on discussions of bringing inflation expectations under control, bringing them down. And to some extent, what was absolutely clear was that what we said we intended to do – and I think we had got credibility – was exactly what the analysts and the monetary journalists thought would happen. So we were very good at getting their expectations more focused on what we intended. What I couldn’t fathom was how this got into the public’s expectations because, unlike industrial countries, we didn’t have strong wage-setting bodies, unions and so on, where you would think the second round of expectations would sort of flow; the unions would maybe read what the analysts are saying and say, “Okay, maybe we should shoot for 3% or 4% inflation in our wage”. We didn’t have a whole lot of that in India. So how did it get from there down to the public’s expectations? If you looked at surveys, they were so far from the actual inflation numbers. I mean, historically they’d always been much higher than the actual inflation numbers, but also how they’ve moved down over time. Yet we brought inflation down from double digits to within our inflation band. I still am not fully sure of how that mechanism worked.
WALKER: Any hunches?
RAJAN: I think things percolate and I think they feed on themselves. And lastly, luck helps if some of the salient aspects of inflation get taken care of – food prices, fuel prices – and they slow down, then people’s expectations become more moderate. But can you target food and fuel? Well, some government management can target food; fuel is much harder, that’s more an international price.
WALKER: Yeah, for India particularly.
RAJAN: For India particularly. But I think things percolate, but it’s not as… Sometimes when you read these papers in journals: “the central bank sets a particular inflation objective and it somehow gets internalised by the system.” That step, there’s a lot of hocus pocus in how that happens.
WALKER: A bit of magic. So you oversaw the introduction of India’s inflation-targeting scheme, and India’s inflation target obviously is 4% plus or minus 2%. How was that target derived?
RAJAN: Well that’s much simpler, right? I started with this notion that, look, a salient price is the rupee–dollar exchange rate. That’s what a lot of people focus on and seem to think that that’s an important indicator of the strength of the economy but also what’s going on and inflation et cetera. So, let’s try to have an inflation target which would keep that nominal exchange rate reasonably stable. If we have around 2% real productivity growth, maybe with a 4% inflation, our nominal exchange rate would be relatively stable against the dollar. So it was as simple as that.
WALKER: I mean, not to belabour this point but just generally, doesn’t it strike you as odd how arbitrarily these numbers can be picked?
WALKER: Given they’re so important.
RAJAN: I don’t think it matters that much.
WALKER: It’s more that they’re low and you just hit them consistently?
RAJAN: Yeah, I think that’s what’s more important. And this is where I think people say, “Oh, 2% is too low; let’s go to 4”. Well, there’s never a good time to do that. If you are way above 2[%] and you say, let’s go to 4[%], it sounds like you’re admitting defeat. I can’t get back to 2[%].
WALKER: “Let’s change the goalpost.”
RAJAN: Therefore let’s change the goalpost. And, of course, if you are at 2[%] or below 2[%] and you say 4[%], sometimes the problem when you’re below two is really getting inflation up. That was the whole problem before the pandemic, right? The Fed had too low inflation. I think it was 1.2% or something over the previous decade before it changed its framework and said, look, we really need to get it up. But it ignored people who were saying, “Say, 4[%],” because it seemed a little ridiculous: you can’t reach 2[%], so you say 4[%] instead. What it did was, it changed the framework to be a little more accommodating of inflation.
I would say it doesn’t really matter what number you pick, so long as it is below the radar screen of people. But what is important, I think what I would say as far as the inflation target goes, is we have much better tools, we have much better understanding how to bring inflation down. We are much less capable of pushing inflation up when it is low. At the same time, it’s probably not that problematic if it’s 1% and your inflation target is 2[%]. The world doesn’t come to an end because of that. It’s just that people still don’t pay attention to inflation. It’s when it’s galloping deflation that it becomes a problem.
And yet we haven’t seen galloping deflation anywhere since perhaps the Great Depression. And so, I would say be a little more relaxed on the downside. Don’t say that I’m underperforming my inflation target, I have to pull out all stops and find some new monetary tool to expand the economy; instead, say, okay, what I’ll do is when it exceeds the target, I will bring it back to the target. When it is below the target, I’ll be a little more relaxed. It may be a sign that I can be a little more accommodative, but I’m not going to get aggressive on it. Because if I start getting aggressive and trying to push inflation up, bad things can happen.
2. Economic ideologies in various central banks
WALKER: On that ‘50 Shades of QE’ paper, just for people wondering, I think they find that papers written by central banks are broadly positive about the effects of QE. Papers written by academic economists are ambivalent, and then the Bundesbank is like moderately negative.
RAJAN: Exactly, and it’s the Bundesbank which is the most interesting. Here’s a central bank, except that the official view in that central bank is generally negative on aggressive monetary policy and – surprise – it doesn’t find a positive result.
WALKER: And what’s the path dependence or history of that institution that makes it negative about QE?
RAJAN: Look, I think that it has historically been conservative. Of course, the German experience with hyperinflation in the ’20s, and at least the hint that it might have led to the rise of Hitler because it wiped out the middle class, is something that they are acutely aware of. The flipside, of course, is, from the American perspective, that the deflation of the ’30s is something that seems to be very strongly embedded in the psyche of American central bankers. If you recall Bernanke’s famous statement to Friedman, you know, “We know the mistake we made then, and we won’t do it again.”
WALKER: Yeah, “You were right”.
RAJAN: Yeah. So in that sense, I think these episodes… And that’s where I came to economic ideology I said earlier in the podcast, right? That’s to some extent what I mean. There is a national ethos that gets embedded into central bank thinking also: “This is what we need to guard against.” So the US is very much guarding against a deflationary episode. Not that we’ve actually seen one in the recent past, but of course the argument could be we haven’t seen one because we’ve been guarding against it. While the Bundesbank is much more worried about inflationary episodes and wants to jump at the first sign that it sees any.
3. Should monetary policy target financial stability?
WALKER: It’s obviously not terribly controversial to say that financial stability should be part of a central bank’s mandate broadly. But should financial stability be a goal of monetary policy specifically?
RAJAN: Here’s the way many central bankers deal with this, right? “Oh, absolutely, we do care about financial stability and obviously we have a whole rationale built up for how we determine monetary policy. But the twain never need meet because we have this fantastic separator called supervision, including prudential macro-supervision, which will somehow make it so that easy money never creates financial instability.” So that’s the separation principle, and central bankers have convinced themselves: once we have the separation principle, we have a monetary policy side that looks at monetary policy. We have a financial stability board, which looks at financial stability. They don’t need to talk to each other. And I think this is rubbish.
WALKER: Can you say more?
RAJAN: I think there’s a very nice paper by José-Luis Peydró and a bunch of co-authors which shows that before every serious financial crisis, you have a period of expansionary monetary policy, interest rates coming down, and then monetary tightening, interest rates going up, and then, boom, it explodes. I think this is basically that the problems are built in a period of easy money – the perverse lending. I mean, no matter how well run the system, easy money makes it possible to make the kinds of loans against booming asset prices, which essentially become problematic down the line. And of course the period of tightening is when the easy money disappears. That’s when – the famous Warren Buffett quote, “you see who’s swimming naked because the tide has gone out”. I think to the extent that central banks are really aggressive in the period of easy money in trying to elevate activity and constrained by their mandates to be aggressive in withdrawing that accommodation in bad times, they put all the adjustment on the financial sector. The financial sector is simply not able to adjust in such a smooth way, and so that’s when things go boom, because leverage builds up in the period of easy money and withdrawing the liquidity, raising interest rates, makes that leverage toxic in the period of tightening money, and that’s when you realise that there are problems.
So is this a law of history? I think it’s sufficiently sort of… you see the pattern time and again before every crisis. If you think about these famous macroprudential tools, the Bank of Spain had macroprudential tools before the global financial crisis and Spain had a rip-roaring banking crisis. So I think when you’re pushing on the monetary accelerator, there’s very little that the supervisory side can do to sort offset that. I mean, we saw it in 2023, right, with Silicon Valley Bank. I mean, what were they thinking? But more, what were the supervisors thinking? And these guys basically loaded up on longer-term debt so that they were effectively decapitalised as interest rates went up. Why didn’t they do basic risk management 101? And you have to believe that, “let me make a small spread, let me pick up pennies before the road roller,” and they got into trouble doing that.
We make the same mistakes again and again. We don’t have to make new ones, but of course we figure out new ways of making mistakes also.
4. The costs and benefits of leaning against the wind
WALKER: I’m sure you’re aware of the cost-benefit analysis by Lars Svensson in 2017 that found that there’s not necessarily a problem in principle with leaning against the wind, but in reality he finds that the costs were more than cleaning up after. What about that analysis didn’t persuade you?
RAJAN: I would be really surprised if any analysis of the global financial crisis and the subsequent political changes which, leading up today, would suggest the costs of that crisis were less than the costs of somewhat more reasonable monetary policy before.
WALKER: Properly accounted for.
RAJAN: Yeah. I just think crises are so dramatic, including in changing your views of the system itself, that I think they’re best avoided. And if it means that you don’t become so aggressive on monetary policy that you have more moderate changes in interest rates, I think almost surely that beats having a crisis. Yeah, you sacrifice some activity. We still sort of have no idea how this is going to play out in the next year or two, whether we’re going to have more turmoil. We still have weak banks in the US, especially the small and medium-sized banks because they’ve gone out on a limb in terms of lending, et cetera.
But this is the cost-benefit analysis we have to ask at some point, right: would easier monetary policy over the last ten years – again, you have to say, relative to what – but if we hadn’t done all the QE, would it have made that much difference? Set aside the risks of higher financial instability. We’ve already had massive Fed intervention by insuring all uninsured deposits in March of this year. What that sets in place for the future, we don’t know. But I think more moderate… I’m not saying you have to be really crazy on monetary policy. I’m saying be a little less aggressive on either side. More moderation. Maybe there’s Friedmanian in it – don’t go chasing after every goal with absolute press the accelerator – press the brake.
5. On the RBA Review
WALKER: Australia recently completed a review of our Reserve Bank. Did you hear about this?
RAJAN: No, I haven’t.
WALKER: Okay. Between 2016 and 2019 the RBA’s concern about high household debt levels and financial instability led it to not cut rates more aggressively. This review, among many other things, effectively concluded or responded with disapproval to that approach. It recommended that the RBA should have a dual monetary policy objective of price stability and full employment, with equal consideration to each, thereby omitting financial stability, although financial stability is to be given a legislative basis in the RBA’s mandate more broadly. But monetary policy should, according to this new review, only focus on price stability and full employment. So given everything we’ve discussed, I presume you would say that is a step in the wrong direction?
RAJAN: Yeah, I think ignoring financial stability is a mistake. I think financial instability is society-changing. If you put some probability on financial instability, I think it’s reasonable to think that you would sacrifice some monetary room for that. So completely ignoring it, I think, is a mistake.