Reconsidering the Case for Price Stability

Goodfriend, Marvin, and Robert G. King. 2001. "The Case for Price Stability." In Why Price Stability? Proceedings of the First ECB Central Banking Conference, edited by A. Garcia-Herrero, V. Gaspar, L. Hoogduin, J. Morgan, and B. Winkler, 53-94. Frankfurt, Germany: European Central Bank.

From the beginning of the Economic and Monetary Union (EMU) in 1999, Marvin Goodfriend was a frequent visitor at the European Central Bank (ECB). As the ECB started its operations, his advice — grounded in long policy experience as well as innovative and highly relevant research — was sought after by ECB policymakers and researchers alike.

The Treaty on European Union gives the ECB the primary mandate of maintaining price stability. The quantitative formulation of the price stability objective was, however, left to the ECB's Governing Council. In its original monetary policy strategy at the start of EMU, the ECB defined price stability as "a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2 percent."¹

It was thus natural when the ECB organized its first central banking conference that the topic should be "Why price stability?" The ECB sought to discuss with a diverse group of economists what price stability should be taken to mean. In their contribution to the conference, Marvin Goodfriend and Robert King (hereafter referred to as GK) made the case for literal price stability.² This conclusion built on the general equilibrium optimal taxation literature in the spirit of Ramsey (1927) and Lucas and Stokey (1983). Following earlier work,³ they used a general equilibrium model augmenting the approach of the real business cycle literature with imperfect competition and costly price setting.⁴ To connect to the optimal taxation literature, GK interpreted the imperfect competition wedge between price and marginal cost — the markup — as analogous to a tax rate.

They then explored under which circumstances this markup should be uniform across time and across states of nature, concluding that optimal policy stabilizes real marginal costs within their model in most circumstances. Moreover, given their presumed link between marginal cost and inflation, such policy also stabilizes the price level. Therefore, GK suggested that a central bank would stabilize markups by credibly maintaining price stability and thus deliver optimal policy. The basic intuition is that markup constancy corresponds to "tax smoothing" over the business cycle or, more generally, to the case for uniform taxation in public finance.

The ECB's original definition of price stability did not exclude such literal price stability or a zero inflation target. However, in the 2003 strategy review, the ECB introduced an inflation aim of "below, but close to 2 percent" within the price stability definition.⁵ Three economic factors were viewed as relevant for justifying a small inflation buffer: i) the existence of downward nominal price and wage rigidities; ii) the persistence of sustained inflation differentials across euro area countries; and iii) the constraint imposed by the zero lower bound (ZLB) on nominal interest rates.

While this formulation of the price stability objective was effective in maintaining long-term inflation expectations close to 2 percent in the inflationary environment of the first decade of EMU, it was problematic in terms of anchoring expectations when disinflationary forces prevailed following the Global Financial Crisis (GFC) in 2008 and the sovereign debt crisis in 2010-2013. In the new ECB monetary policy strategy, announced on July 8, 2021, this formulation was therefore replaced by a symmetric 2 percent inflation target.⁶ Such a symmetric target is simple, clear, and easy to communicate and should therefore help to better anchor long-term inflation expectations. The ECB Governing Council sees the level of 2 percent as representing a good balance between providing a safety margin against the risks of deflation and the welfare costs posed by excessive inflation. With this new symmetric 2 percent inflation target, the ECB has joined many central banks in advanced economies that flexibly target a 2 percent inflation rate.

Why did central banks not move to literal price stability? For example, the Bank of Canada investigated the option of price-level targeting regularly in its periodic review of Canada's inflation-control target, but so far it has always continued with a 2 percent inflation target.⁷

To understand why, our essay highlights four factors not considered in the GK case for literal price stability. Section 2 analyzes the impact of the effective lower bound (ELB) on nominal interest rates, which was central to the revised formulation of the price stability objectives both in the United States and the euro area. Section 3 reconsiders aspects of the GK model, which focused on price rigidities and assumed a perfectly competitive labor market. GK argued this is a reasonable approximation when wages, at any point in time, are nonallocative. We review some recent evidence on wage rigidity and analyses of its implications for the optimal inflation target. Section 4 considers the role of fiscal policy. The main message is that when the ELB limits the ability of monetary policy — acting on its own — to deliver price stability in a timely way, fiscal policy can help to overcome the constraint. Hence, interactions of fiscal and monetary policy become central for the conduct of monetary policy at the ELB. Finally, GK's analysis suggested that literal price stability would also be optimal for a monetary union, arguing that an integrated financial market would provide the necessary insurance against country-specific shocks. Section 5 makes a few observations on the evolution of financial risk sharing in EMU against that background.

Overall, we conclude that these factors significantly undermine the case for literal price stability and support the current practice in most advanced economies of targeting a small positive inflation rate.

The relevance of the effective lower bound on nominal interest rates⁸

Marvin Goodfriend was an early advocate of the importance of interest rates for central bank policy practice and analysis, but the GK analysis was mainly concerned with the behavior of inflation and real activity.⁹ In his comments on GK at the conference, Gali (2001) observed that a zero inflation policy would lead to a very low steady-state level of the nominal interest rate and that GK had not considered the fact that a central bank could not push down nominal interest rates below zero (the ZLB). The assumption in GK was in line with the policy wisdom at the time. For example, at the conference, Jose Vinals (2001) wrote: "In sum, zero bound problems are very rare events and most of their negative consequences can and should be avoided by preventive measures." In the same spirit, when reviewing and revisiting the ECB's monetary policy strategy in 2003, the consensus from a number of studies was that the ZLB was unlikely to bind if the inflation norm was set at 1 percent or higher.¹⁰ Such conclusions were predicated on a 2 to 3 percent range for the equilibrium or natural real interest rate.

Today the perspective is very different as a consequence of policy experience and empirical evidence. Although Japanese short-term interest rates had come close to zero during the mid-1990s, it was only in 1999 that a zero interest rate policy was adopted by the Bank of Japan. At the time, Japan was seen as an interesting but isolated case. Later, the perspective changed as more and more central banks confronted limits on the use of interest rates in monetary policymaking. For example, the ECB encountered the ELB during the sovereign debt crisis in 2010-2011 and has yet to exit it, echoing the Japanese experience. Many other central banks have faced similar circumstances, including the Federal Reserve beginning in late 2008. COVID-19 once again made the ELB relevant for most advanced economies. Today, the ELB has become a fact that policymakers have to take into account in the normal conduct of policy.

The most important reason for why nominal interest rates have been close to the ELB is the gradual fall in the natural real interest rate, frequently called r*. This has been a global phenomenon driven by a combination of factors such as lower population and productivity growth, rising inequality, and higher demand for safe assets following the GFC. Brand et al (2018) survey a range of estimates of r* for the euro area from 1999 to 2019. While the estimated level of r* differs across methodologies, all estimates point to a significant decline over this period from a range of 2 to 3 percent to one of 0 to -2%.

A lower natural rate implies that the ELB is more likely to keep a central bank from lowering real rates to offset disinflationary forces. On the basis of stochastic simulations using a variety of macroeconomic models for the euro area, ECB (2021b, p. 36) shows that — for an inflation target of 2 percent — the time spent at the effective lower bound increases from 10 percent to more than 30 percent as the equilibrium real interest rate falls from 2 to 0 percent. The likelihood of a binding ELB has also increased due to changes in estimated macro volatility. In 2003, the variance of the demand and supply shocks affecting the economy was assumed to be relatively low, consistent with the experience in the Great Moderation period. Following the GFC, the volatility of the economy has increased. This higher volatility may be related to the fall in the equilibrium real interest rate. Adam (2020) finds that with a low r*, the sensitivity of the business cycle to asset price bubbles increases, which in turn increases the volatility of the economy, the time spent at the ELB, and the optimal inflation target. A higher inflation target reduces the relevance of this constraint as, for example, also shown in Andrade et al (2019), who find that the optimal inflation target increases by 0.9 percentage point for each 1 percentage point fall in r*. An additional factor that may have contributed to an increase in the optimal inflation target is increased inequality. It not only may have contributed to the fall in the equilibrium real rate,¹¹ but can also make the economy more sensitive to the real interest rate increases that occur at the ELB as low-income households typically are more affected and have a larger propensity to consume than richer ones.¹²

Without the use of nonstandard monetary policy measures such as forward guidance or asset purchases, a 2 percent inflation target is likely not enough to avoid a disinflationary bias when the equilibrium rate is zero. Depending on the model used, this disinflation bias can be sizeable, even with a 2 percent inflation target.¹³ Forward guidance and other nonstandard policy measures such as asset purchases and targeted long-term lending operations can however help to overcome this bias as, for example, shown in Coenen et al (2020, 2021), Gerke, Kienzler, and Scheer (2021), and Mazelis, Motto, and Ristiniemi (2021).

The ECB's new monetary policy strategy consequently takes into account the implications of the ELB for its reaction function.¹⁴ In particular, when the economy is close to the lower bound, the commitment to the symmetry of its 2 percent inflation target requires especially forceful and persistent monetary policy measures. These preclude negative deviations of inflation from the target becoming entrenched. Such forceful action may include the use of large-scale asset purchases or targeted long-term refinancing operations, which are now part of the central bank's instrument set and were implemented in response to the pandemic crisis. In addition, closer to the ELB, a more persistent use of such instruments may be necessary, which could lead to a transitory period in which inflation is moderately above target. The Fed has implemented the more persistent use of its instruments through an asymmetric average inflation targeting framework. By contrast, the ECB has implemented the need for persistence and patience through a strengthened threshold-based interest rate forward guidance.

Downward nominal wage rigidities and the inflation buffer¹⁵

GK assumed a perfectly competitive labor market. While they acknowledge that there may be labor market frictions that lead to equilibrium unemployment, they argue that wages — at any given point in time — do not play an allocative role. In such an environment, nominal rigidity in wage formation does not matter. At the conference, though, Wyplosz (2001) argued that the importance of downward nominal wage rigidity (DNWR) may justify a positive inflation target, following the work of Akerlof, Dickens, and Perry (1997). DNWR leads to a non-vertical long-run Phillips curve and introduces an exploitable monetary policy trade-off at low levels of inflation. Based on estimates of the slope of a long-run Phillips curve for the euro area, Wyplosz suggested an optimal inflation target of 4 percent.

Since 2001, a lot of empirical evidence has been collected on the relevance of price and wage rigidities in the euro area and beyond. Consolo et al (2021) review the accumulated evidence on price and wage rigidities in the euro area since the early 2000s: they find evidence of both price and wage rigidities in the euro area. However, price flexibility may have increased during the EMU period, in particular in the more traded nonenergy industrial goods category, and there is little evidence of pervasive downward price rigidity. By itself, this would suggest that a zero inflation target is optimal to avoid misallocations due to inefficient relative price changes when inflation is positive.¹⁶

In contrast, evidence from the ECB's Wage Dynamics Network (WDN) surveys suggest that the length of wage contracts may have increased and, more importantly, that nominal base wages are very sticky downward. According to the WDN surveys, nominal base wage cuts are very rare among euro area firms. Remarkably, this was the case even during the period 2010-2013 despite the length and severity of the sovereign debt crisis.¹⁷ Downward nominal rigidity during the crisis is further suggested by the fact that the percentage of firms freezing base wages increased dramatically, reaching its peak during 2008-09, before declining over the period 2010-13. The WDN surveys also find that the wages of new hires are closely related to those of incumbents suggesting that wages do play an allocative role.¹⁸

For the US economy, using high-quality administrative data, Grisgby et al. (2021) finds that downward wage rigidity is more pervasive than previously measured with the nominal base wage declining only for 2 percent of job stayers. These researchers also find that the flexibility of base wages of new hires is similar to that of incumbent workers.

This euro area and US evidence suggests that higher real wages due to a binding downward nominal wage constraint may lead to persistent effects of aggregate demand on unemployment, with relatively high real wages depressing hiring and increasing unemployment duration. For instance, according to Daly and Hobijn (2014), DNWR provides a rationale for persistent US output losses during the GFC.

Turning to the implications for monetary policy, we stress that DNWR provides a rationale for a positive inflation buffer as it "greases the wheels" of the labor market.¹⁹ New Keynesian DSGE models with exogenous growth that embed DNWR find that the optimal inflation rate is positive, although it is usually below 2 percent. Specifically, the calibrated DSGE model developed in Consolo et al (2021) provides a point estimate for the optimal inflation rate of about 1.2 percent with a confidence band ranging from 0.2 to 1.6 percent.

A surprising conclusion of some recent research is that the introduction of DNWR in a model with the ZLB reduces the optimal inflation rate.²⁰ The mechanism is that wage rigidities limit the frequency and the persistence of the ZLB by keeping marginal costs relatively higher. In the quantitative analysis of Consolo et al (2021), discussed earlier, the introduction of the ZLB leads to a lower optimal inflation rate from 1.2 to 0.3 percent. These results are, however, overturned in DSGE models that feature equilibrium unemployment and endogenous growth as in Abritti and Consolo (2021). Such models support a symmetric inflation buffer around 2 percent.²¹ From a welfare perspective, the optimal rate of inflation balances welfare costs of price inflation distortions and hysteresis effects on output and unemployment. Over all, recent empirical studies and investigations with quantitative models lead to a robust conclusion that DNWR leads to a positive average optimal inflation rate, even in the presence of the ELB — reinforcing the logic that has led the ECB to choose a 2 percent rather than 0 percent target over the years.

Fiscal-monetary policy interaction and the ELB

The GK framework identifies a clear division of labor between fiscal and monetary policy. Optimal fiscal policy compensates for the permanent distortions in the economy. For example, a wage subsidy can compensate for the average markup. Optimal monetary policy, in contrast, focuses on stabilizing the markup over the course of the business cycle. Such a perspective leads to fiscal policy as structural policy. Fiscal policy is crucial to provide incentives to work and save, accumulate knowledge, and innovate. Fiscal policy is, therefore, aimed at growth, employment, resource allocation, and the distribution of income and wealth. In contrast, monetary policy focuses on keeping the economy close to potential at business cycle frequencies.²²

Recent reviews of monetary policy strategy by the Federal Reserve and by the ECB explicitly recognize the relevance of the ELB for monetary-fiscal interactions.²³ Specifically, when the optimal policy interest rate is substantially lower than allowed by the ELB, the monetary authority typically uses forward guidance and communicates that interest rates will be kept low for an extended period. Fiscal multipliers are larger under these conditions than when monetary policy adjusts the policy rate according to a typical reaction function. Fiscal policy thus can assist monetary policy in avoiding recessions and restoring price stability. The power of fiscal policy is greatest when it is needed the most.

Ramey and Zubairy (2018) provide empirical evidence of a government spending multiplier of 1.5, for the United States, at the ZLB. Similarly, Klein and Winkler (2021), using an historical panel, also find a multiplier of 1.5 at the ZLB. There is a vast model-based literature arguing that multipliers can be very large at the ZLB. It includes Christiano, Eichenbaum, and Rebelo (2011), Eggertsson (2011), Woodford (2011), and Woodford and Xie (2020). Although Boneva, Braun, and Waki (2016) show that the effect of fiscal policy may be smaller than multipliers reported in the literature, they still come out with a multiplier above 1, at 1.05.

ECB (2021c, p. 72 and ff) presents simulations using the ECB-BASE model that shed light on monetary-fiscal policy interactions at the ELB. Looking at negative scenarios, the simulations show that fiscal stabilization policy stays effective at the ELB. In contrast, monetary policy rates are constrained so that the contribution from monetary policy is limited to nonstandard measures. In the concluding section, ECB (2021c) argues that there are substantial benefits from monetary-fiscal policy coordination that would result from well-calibrated changes to the euro area macroeconomic policy architecture.

The bottom line is that the ELB limits the ability of monetary policy — acting on its own — to deliver price stability in a timely way. But fiscal policy can help to overcome the constraint. Hence, fiscal-monetary policy interactions are becoming central for the conduct of monetary policy at the ELB.

Financial frictions, monetary operations, and credit market imperfections

GK use principles of public finance to determine whether price stability can be expected to be a good approximation of optimal monetary policy under more general circumstances than afforded by the basic closed economy model. One very interesting extension discussed by GK is the case of a small open economy, taken to mean that private agents and the government can trade in complete world financial markets at given prices. In such a setting, financial variables and wealth are stabilized by access to world finance. The small open economy gets full insurance, at fair prices, against idiosyncratic shocks. The setup is not without problems. Tirole (2002) argues that a country's moral hazard limits its access to financing. In the presence of asymmetric/incomplete information and government incentive problems, the complete market assumption may not be a particularly useful benchmark. In general, the financial structure will have to reflect government information and incentives.

But, in 2001, monetary unification was seen as a major force leading to financial market integration. Financial union — a single European market — might not yet be realized but, with time, deeper financial integration would amplify the benefits from the euro. Fast progress since the late 1990s toward the integration of bond markets and interbank money markets seemed in line with such an optimistic view. At the global level, too, there was the Great Moderation. It was a period of relative stability from the late 1980s to the GFC. After the first 10 years of the euro, the prospects looked bright.

Unfortunately, the process of gradual financial integration in Europe was put into reverse as the GFC morphed into sovereign debt crises. As feared by the founding fathers of the euro, financial markets abruptly fragmented under stress.²⁴ A strong correlation emerged between sovereign risk and bank risk. The phenomenon became so salient that it got a special name: the doom loop.²⁵ One version of the mechanism is as follows. First, the sovereign comes under stress, so that bank balance sheets deteriorate given their exposure to the sovereign. Second, financing conditions tighten as credit spreads widen. Third, investment and economic activity declines, leading loan defaults to increase. In turn, the balance sheets of banks deteriorate further. Finally, public debt and deficits widen, closing the loop. This loop is one explanation of the well-known high correlation between private and public credit default swaps.

Now, it is impossible for us to see the abstract complete markets model as a relevant benchmark. During the decade beginning in 2008, the fragilities of the European pattern of financial integration came into sharp focus. For central banking, these fragilities affected the monetary transmission mechanism and, through it, the single monetary policy.

One particular challenge may come from self-fulfilling debt crises. When the sovereign is vulnerable and there is the possibility of a rollover crisis, there may be multiple equilibria. In such a crisis, there is a new role for a central bank: it can tilt the balance toward the good equilibrium.²⁶ In some cases, action through intervention in markets may not even be required. The euro area provided the perfect example in 2012. In the early summer, bond yields on Spanish and Italian bonds were heading to levels that in previous experience had triggered bond market crises. It was in this context that Mario Draghi famously stated: "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro." The statement was enough to calm markets. "Whatever it takes" became the three most famous words in the history of European monetary and financial integration.²⁷

An important implication for central bankers is that, given multiple financial market frictions and the fragmentation of the single financial market, the operational framework for monetary policy implementation becomes very relevant. The simplicity of monetary policy implementation through a money market interest rate is lost. The management of the central bank's balance sheet becomes a matter of concern. The details of monetary policy implementation matter. This is particularly the case in crises. The last decade provides a rich illustration.

Summing up

As presented at the first ECB central banking conference in 2001, the GK analytical policy framework based on imperfect competition and price rigidity provided an intuitive and elegant rationale for central banks pursuing literal price stability. In this essay, we argue that additional frictions — including the ELB on nominal interest rates and DNWR — can explain why central banks in the advanced economies have instead targeted a small positive inflation rate of 2 percent.

We also argue that monetary policy may not be enough to achieve the 2 percent target. With a zero or negative natural real interest rate, fiscal policy may also have to take on a macroeconomic stabilization role to avoid inflation becoming trapped too close to zero. Moreover, incomplete banking union and capital markets union makes departures from the complete contingent markets' paradigm employed by GK painfully visible. The magnitude of financial instability and its consequences for economic activity and employment were salient during the sovereign debt crises in the euro area from 2010-13.

Yet, our bottom line is that the case for price stability, understood as low and stable inflation, at say 2 percent, remains strong. The gradual fall of the real natural interest rate, in the euro area, to the range of 0 to -2 percent, makes it more likely that policy interest rates will be constrained by the ELB. In such circumstances, it is important that the conduct of policies be patient and persistent, with particular attention paid to the interaction of monetary and fiscal policy.

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Cite as: Gaspar, Vitor, and Frank Smets. 2022. "Reconsidering the Case for Price Stability." In Essays in Honor of Marvin Goodfriend: Economist and Central Banker, edited by Robert G. King and Alexander L. Wolman. Richmond, Va.: Federal Reserve Bank of Richmond.