Why Central Banks Should Not Be Inflation Nutters

By Davide Debortoli, Associate Professor, Universitat Pompeu Fabra. Jinill Kim, Professor, Department of Economics, Korea University, Jesper Lindé, Researcher at Sveriges Riksbank and CEPR Research Affiliate, and Ricardo Nunes, Professor, School of Economics, University of Surrey. Originally published at

Previous studies have suggested that for central banks, a focus on inflation stabilisation is enough to stabilise other macroeconomic variables, and that focusing on economic activity can even be harmful. Using a model similar to those in use at central banks, this column studies the welfare implications of increasing the weight on economic activity in the central bank’s objective. The results suggest that stabilising measures of economic activity should be one of the primary objectives of central banks, as important as or even more important than stabilising inflation around its target.

The Global Crisis and the European sovereign debt crisis have stimulated an intense debate about the role of central banks. Should central banks be responsible for price stability, for the stability of economic activity, or both? For example, while the ECB’s primary objective is to maintain price stability without any explicit responsibility for economic activity, the US Federal Reserve’s objective is to promote maximum sustainable employment in a context of price stability.1Is this dual mandate beneficial for the society, or is the ECB’s inflation mandate preferable?

The literature to date, most notably the influential work by Woodford (2003), suggests that a focus on inflation stabilisation is enough to stabilise other macroeconomic variables, and that focusing on economic activity can even be harmful. In a recent paper, we challenge this view by arguing that stabilising measures of economic activity should be one of the primary objectives of central banks, as important as or even more important than stabilising inflation around its target (Debortoli et al. 2018).

Why a DualMandate Rather Than MultipleMandates?

A central bank should in principle take into account all the economic variables affecting social welfare. Yet, no advanced country asks its central bank to do so. Instead, central banks are mandated to pursue simple objectives that involve only a few variables. Why? Because simple objectives facilitate the communication of policy actions to the public, make monetary policy more transparent, and enhance the accountability of the central bank.

But simplicity comes at a cost. Looking at only a few variables is typically inefficient, in the sense that it generates some welfare loss with respect to adopting a more complete, although complex, criterion. A natural question then arises: How can we design objectives for central banks that are simple, but that would generate the smallest possible welfare losses?

What Are the Most Important Variables? Inflation or Economic Activity?

Central bank objectives are typically formulated in terms of two variables: inflation and output. Such a specification captures the main challenge facing central banks. Consider for instance an economy suddenly affected by an exogenous decline in demand. If a central bank wants to stimulate economic activity, it will have to tolerate some inflation, either on prices or wages, which is costly to the society. Alternatively, if the central bank wishes to keep prices and wages constant, it would have to tolerate a decline in output. The main question is therefore how to strike a good balance between the two conflicting objectives.

What Weight Should Be Given to Economic Activity? Much Greater Than Previously Thought

A common result in the monetary policy literature is that stabilising measures of economic activity should receive a small weight relative to stabilising inflation. For example, the seminal work of Woodford (2003) shows that within a simple model with sticky prices, the optimal weight on output stabilization is negligible, only 4.8% of the weight on inflation. In contrast, according to a speech by Janet Yellen (2012) – who was later to become the chair of the Federal Reserve – the Federal Reserve’s dual mandateimplies a weight on economic activity of about 25% of the weight on inflation, a value considerably higher than those usually considered in the academic literature.

Our work revisits these results. In contrast to previous works, we consider an economic model similar to those actually in use at central banks and policy institutions.2The model is used as a laboratory to study the welfare implications of increasing the weight on economic activity in the central bank’s objective. A key finding is that the weight that minimises the welfare losses is higher than the values considered in the academic literature so far, regardless of the specific measures of economic activity considered (we study the output gap, output as deviation from a linear trend, and output growth). For a standard loss function with annualised inflation (deviations around target) and the output gap (actual minus potential output), our baseline specification suggests equal weights on inflation and the output gap. That is, the optimal weight on the output gap is about 20 times higher than that of Woodford (2003) and four times higher than the number in Yellen (2012).

Why a High Weight on Economic Activity? It Depends on the Structure of the Economy

The key driver of these results is that stabilising economic activity helps stabilising other welfare relevant variables that are not included in the central bank’s simple objective. Intuitively, the desirability of stabilising the output gap depends on the welfare costs associated with price and wage inflation. In economies with sizeable wage rigidities, stabilising economic activity is more desirable since it helps stabilising wage inflation, which generates high welfare costs. In contrast, in economies where prices are much more rigid than wages, the central bank should focus on maintaining price stability, and thus the optimal weight on economic activity should be low.

The same logic applies to other sources of inefficiencies, such as labour market frictions, monopolistic power in the goods market, and so on. Stabilising economic activity may help mitigating the costs associated to those inefficiencies.

Through a series of quantitative exercises, we show that the weight on economic activity should be high in a variety of scenarios. For instance, the result is robust to the presence of substantial measurement errors of the output gap (or potential output), to the presence of shocks that generate a trade-off between stabilising inflation and economic activity, and also when ensuring a low probability of hitting the zero lower bound on nominal interest rates.

Central Banks Should Target  Economic Activity When Inflation Expectations Are Anchored

All told, our key point is to argue that the academic consensus that central banks should primarily focus on price stability may not be right. As suggested by the seminal work by Kydland and Prescott (1977) and Barro and Gordon (1982), attaching a small weight on economic activity might help establish the credibility of a central bank during the inception of an inflation targeting regime. However, once such credibility has been established, our work suggests that central banks should also target measures of economic activity as well as aiming at price stabilisation whenever the economy is affected by non-trivial rigidities and inefficient shocks. In the terminology of Svensson (2010), our findings underscore the importance of ‘flexible inflation targeting’ with a prominent role for resource utilisation. This is particularly important today as fiscal constraints, in the form of stringent debt and deficit rules or elevated debt levels following the global financial crisis, may limit the scope for fiscal policy to promote economic stability going forward.

Finally, targeting economic activity also helps to address the financial cycle.The financial cycle and the emergence of the global financial crisis have by some commentators been advocated as a major limitation of the standard inflation targeting framework. Adding economic activity as an explicit target on par with inflation provides a central bank with a clear rationale to hike rates when the economy is running above potential even if inflation is projected to be below its target for some time.

Authors’ note: Anyviews expressed in this column are solely the responsibility of the authors and should not be interpreted as reflecting the views of Sveriges Riksbank.

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18 comments

  1. Sound of the Suburbs

    Problem solving involves two steps.

    1) Understand the problem
    2) Find a solution

    Post 2008 – “It was a black swan”.

    We didn’t complete step 1, so our solution was a bit of a stab in the dark.

    Twelve people were officially recognised by Bezemer in 2009 as having seen 2008 coming, announcing it publicly beforehand and having good reasoning behind their predictions.

    What do they say?
    You can’t solve a debt problem with more debt.

    What have we been trying to do?
    Solve a debt problem with more debt.

    This is why you should complete step 1 first.

    What does it look like?

    We just need another Great Depression to clear down the debt.

  2. diptherio

    If a central bank wants to stimulate economic activity, it will have to tolerate some inflation, either on prices or wages, which is costly to the society.

    Increasing wages is costly to society….really now? Who is this “society” anyway? Is it not just a conglomeration of individual people, most all of whom work for wages? So if people are getting more money for their labor, why is that viewed as a cost, rather than a benefit?

    Oh right, because all mainstream (and much non-mainstream) economics is produced from the perspective of a corporate CEO, not a working stiff, and therefore, wages are counted as costs. This is why I work in worker co-ops, because there when workers get more money it’s cause for celebration, not nail-biting.

    1. Ignacio

      I guess the author considers wage increases relative to wages in other countries. If there are relative wage increases you will supposedly end with commercial deficit and that is “costly” because your “competitivity” is reduced.

  3. Susan the other

    Using the term “economic activity” implies a wide range of options to stabilize the welfare of society economically. Using the economy itself as the agent of stability. Multiple mandates are required. This is such good common sense it is profound. The authors wisely include a parameter – available resources – to use as a foundation for economic stimulus that does not cause inflation. This is going to be interesting because resources can get bottlenecked (as the analysis indicates)… So, this is a very profound analysis because if we accept the premise of stability and balance of the economy for the welfare of society, then we have to change the system.

  4. nothing but the truth

    inflation destroys (whatever is left of) purchasing power of people who work for their money (as opposed to those who own assets and wait for them to increase in value due to inflation).

    This is so clear if you look at inflation and wage data since 1970 (when the dollar became a full paper currency).

    Since 1970, real wages have been stagnant, while asset prices have gone up zillions of times.

    Will economists be convinced ? No.

    Do they matter ? Yes, to spread the gospel of inflation to the public.

    Do they matter while the PTB make decisions? No.

    1. David Swan

      Wages have been stagnant since the 70s precisely because of the central banks’ approach to mitigating inflation, which is to suppress employment to a level that will prevent wage gains. What this has to do with a “gospel of inflation” I couldn’t begin to guess – sounds like gold nutter talk.

  5. Grebo

    Giving central banks the right goals is obviously a good idea, but it won’t have much benefit as long as the banks have a back asswards idea of how to achieve those goals.
    The authors of this piece don’t seem to notice that problem.

  6. JBird

    I don’t know how apropos, or not this is, but this does remind me of the central banks obsession with gold backed currency in the 19th and early 20th century, to the point where even adding silver to the standard was usually ignored; unless there was a war to finance then the gold standard was dumped where possible as in the First World War, but right after the war the central banks insisted on returning to the gold standard, even when the various economies crashed.

  7. KFritz

    A thought for the mix. Limiting inflation protects savers to some degree. At the moment savers in the US are losing a steady, predictable amount of the actual value of their savings. The situation resembles a substandard but not starvation level diet. As I understand it, inflation would wipe out us (full disclosure) savers. If all this is correct, the inflation hawkishness of Banks may be the best deal savers are going to get in a distorted economy. If so, for one, until sanity alters the distorted economy, I’ll take it.

    1. David Swan

      Savers should make better decisions. Buy gold if you are concerned your savings would be eroded if we allowed (or influenced) employment and wages to rise. Your concerns are noted, but of a lower priority than maximizing economic output.

  8. TheScream

    I don’t understand this line: ” if the central bank wishes to keep prices and wages constant, it would have to tolerate a decline in output.”. Bear in mind I have a masters in economics, so I am not just dumb. I simply don’t believe that constant wages imply stable or declining output. This is pro-inflationary propaganda.

    1. James

      Better question: what’s so bad about stable – or dare I say it, slightly declining output – in the first place? How much useless crap do we really need to produce before we decide enough is enough? That is pro-inflationary propaganda of the more basic kind.

    2. Anonimo2

      You would indeed need a master in economics to be unable to understand something so trivial.

      If wages do not grow, demand will not grow and therefore neither will output.

      1. TheScream

        Thanks for the insult. Always nice.
        If wages refer to overall wage budget for the country, then this is still not true. Why would output decline in a steady economy (stable wages and stable prices)? If individual wages remain stable (.g. everyone earns $10 an hour), then population growth will automatically increase demand.
        Would you like an ad hominem retort? I invite you to make one up on your own and put it on my account.

        1. larry

          You have added pop growth into your scenario. Although you are right to do so, in the context, this is naughty, though not according to the pseudomath used in virtually all economics programs. And, just because you have a Masters in neoliberal economics does not mean that you were taught much of anything about the economics of the real world.

          1. TheScream

            Okay, I get it. Everyone thinks economists are assholes. I never said I was a neoliberal (my masters degree was from a fairly left-wing institution). Thank you, but I am not an economist and have never been one. I spent my career in the real world doing real things.
            So my question still stands. I am not the one making all kinds of “neoliberal” and “academic” assumptions. I am simply asking why stable wages and stable prices lead to declining output. If you have an answer, please provide one. If you don’t, please consider that I have been insulted twice so unless you have a real witty zinger, do your best to refrain.

  9. knowbuddhau

    Enter the irrational.

    This is particularly important today as fiscal constraints, in the form of stringent debt and deficit rules or elevated debt levels following the global financial crisis, may limit the scope for fiscal policy to promote economic stability going forward.

    The debt ceiling, IIUC, serves the same function as a cliff in a cliffhanger. It’s an arbitrary, self-imposed, kabuki trigger. And creating debt only to cry, “Our hands are tied!” is even older hat.

    What’s their real purpose? They declare themselves “independent” of the polity. Why should they be expected to act in our interest? What does the evidence say? They might as well put on those old school robber masks while they’re at it.

    If the largest share of gains since the crash have gone to people not making wages, why do we still need to keep wages down, lagging behind productivity like they’ve been for 40-odd years? We have a consumer-driven economy in which the wages are set just above subsistence, and a whole different ball game, FIRE, where it’s “performance be damned, just gimme more.” How do they expect consumers to drive the economy if the keep minimizing wages?

    Crazy thought: they don’t. We’re not their constituency. We can wonder a million ways till sundown, what might it take for them not to be what they plainly are. They’ll not wast any more of their precious treasure on the and care of us brutes than they have to. IMNSHO.

  10. knowbuddhau

    On wages versus productivity from

    The [EPI] report, “,” by economists Lawrence Mishel and Heidi Shierholz, finds that American workers across the board — whether in the private or public sector, high school- or college-educated –- “have suffered from decades of stagnating wages despite large gains in productivity.” The trend isn’t new, either. Between 1979 and 2009, EPI says, U.S. productivity increased by 80 percent, while the hourly wage of the median worker has only gone up by 10.1 percent.

    Same effect. Decades long. A 70-point spread (assuming they’re comparable). Meanwhile, insane income at the top, often for making our lives living hells, and mostly adding nothing of real value.

    Where’s the rationality, or even some basic empiricism? Making sure things don’t add up is why, I suppose, some get the big bucks.

    Whatever impediment we might, through their system, put in their path, a way will be found around it.

    That tired old melodrama has been upstaged by climate change. We’re supposed to be decarbonizing like there’s no tomorrow, and they’re still playing Plantation.

    Meanwhile, Forces Majeur are taking center stage more often and longer than ever, with record catastrophic performances the new normal. Time’s wasting.

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