Sunday, March 7, 2010

Comment on Blanchard and Trichet (amv)

Below, fg posted Trichet's response to Blanchard's suggestion to increase the target rate from approximately 2% to 4%. Trichet is highly negative. It should be noted however that the entire debate could be resolved by switching to level targeting. Trichet is worried about discretionary changes in targets since this would destabilize mid- and long-run expectations. Trichet is right. You cannot endogenize the rules of the game and still anchor expectations. 'We promise to target inflation at a rate of 2 percent as long as we don't wish to do otherwise.' Such policy, especially if credible, is devastating. What, however, if the rules of the game themselves ask markets to increase expected inflation rates in face of a negative shock to the level target, that is, to motivate the optimal market reaction by the very ex ante rules followed? Level targeting increases inflation-expectations as soon as the price level shifts below target. Both, Blanchard and Trichet, get what they want: more activity by the institutional setting. Given the discussion, level targeting seems to be a free lunch (indicating that science and policy may not be as efficient as are markets).