Inflation targeting – an unmitigated failure

22 Mar, 2013 at 16:18 | Posted in Economics | 4 Comments


The Riksbank in 1993 announced an official target for CPI inflation of 2 percent. Over the last 15 years, average CPI inflation has equaled 1.4 percent and has thus fallen short of the target by 0.6 percentage points. Has this undershooting of the inflation target had any costs in terms of higher average unemployment? This depends on whether the long-run Phillips curve in Sweden is vertical or not. During the last 15 years, inflation expectations in Sweden have become anchored to the inflation target in the sense that average inflation expectations have been close to the target. The inflation target has thus become credible. If inflation expectations are anchored to the target also when average inflation deviates from the target, the long-run Phillips curve is no longer vertical but downward-sloping. Then average inflation below the credible target means that average unemployment is higher than the rationalexpectations steady-state (RESS) unemployment rate. The data indicate that the average unemployment rate has been 0.8 percentage points higher than the RESS rate over the last 15 years. This is a large unemployment cost of undershooting the inflation target. Some simple robustness tests indicate that the estimate of the unemployment cost is rather robust, but the estimate is preliminary and further scrutiny is needed to assess its robustness.

During 1997-2011, average CPI inflation has fallen short of the inflation target of 2 percent by 0.6 percentage points. But average inflation expectations according to the TNS Sifo Prospera survey have been close to the target. Thus, average inflation expectations have been anchored to the target and the target has become credible. If average inflation expectations are anchored to the target when average inflation differ from the target, the long-run Phillips curve is not vertical. Then lower average inflation means higher average unemployment. The data indicate that average inflation below target has been associated with average unemployment being 0.8 percentage points higher over the last 15 years than would have been the case if average inflation had been equal to the target. This is a large unemployment cost of average inflation below a credible target. Some simple robustness tests indicate that the estimate of the unemployment cost is rather robust, but the estimate is preliminary and further scrutiny is needed to assess its robustness.

The difference between average inflation and average inflation expectations and the apparent existence of a downward-sloping long-run Phillips curve raises several urgent questions that I believe need to be addressed. Why have average inflation expectations exceeded average inflation for 15 years? Why has average inflation fallen below the target for 15 years? Could average inflation have fallen below average inflation expectations and the inflation target without the large unemployment cost estimated here? Could the large unemployment cost have been avoided with a different monetary policy? What are the policy implications for the future? Do these findings make price-level targeting or the targeting of average inflation over a longer period relatively more attractive, since they would better ensure that average inflation over longer periods equals the target?

Lars E.O. Svensson, The Possible Unemployment Cost of Average Inflation below a Credible Target

According to Lars E. O. Svensson – deputy governor of the Riksbank – the Swedish Riksbank has been pursuing a policy during the years 1998-2011 that in reality has made inflation on average 0.6 percentage units lower than the goal set by the Riksbank. The Phillips Curve he estimates shows that unemployment as a result of this overly “austere” inflation level has been almost 1% higher than if one had stuck to the set inflation goal of 2%.

What Svensson is saying, without so many words, is that the Swedish Fed for no reason at all has made people unemployed. As a consequence of a faulty monetary policy the unemployment is considerably higher than it would have been if the Swedish Fed had done its job adequately.

From a more methodological point of view it is of course also interesting to consider the use made of the rational expectations hypothesis in these model-based calculations (and models of the same ilk that abounds in “modern” macroeconomics). When data tells us that “average inflation expectations exceeded average inflation for 15 years” – wouldn’t it be high time to put the REH where it belongs – in the dustbin of history!

To me Svensson’s paper basically confirms what I wrote a couple of months ago:

Models based on REH impute beliefs to the agents that is not based on any real informational considerations, but simply stipulated to make the models mathematically-statistically tractable.

Of course you can make assumptions based on tractability, but then you do also have to take into account the necessary trade-off in terms of the ability to make relevant and valid statements on the intended target system.

Mathematical tractability cannot be the ultimate arbiter in science when it comes to modeling real world target systems. Of course, one could perhaps accept REH if it had produced lots of verified predictions and good explanations. But it has done nothing of the kind. Therefore the burden of proof is on those who still want to use models built on ridiculously unreal assumptions – models devoid of all empirical interest.

In reality, REH is a rather harmful modeling assumption, since it contributes to perpetuating the ongoing transformation of economics into a kind of science-fiction-economics. If economics is to guide us, help us make forecasts, explain or better understand real world phenomena, it is in fact next to worthless.



    “Svidande kritik mot Riksbankens redogörelse
    I en unik reservation sågar vice riksbankschefen Lars E O Svensson skriften Redogörelse för penningpolitiken 2012, som Riksbanken nyligen skickade till Riksdagen.
    Reservationen är historisk, enligt Riksbanken.

    Det har aldrig hänt tidigare att en medlem i Riksbankens direktion reserverat sig mot Redogörelsen för penningpolitiken.

    – I så måtto är Lars E O Svenssons åtgärd historisk. Å andra sidan är hans reservation kanske inte så konstig eftersom Lars gång på gång har opponerat sig mot den förda penningpolitiken de senaste åren, säger Tomas Lundberg, presschef på Riksbanken.

    LÄS OCKSÅ Vice riksbankschefen orolig för hushållen

    Det handlar inte om någon kortfattad reservation på tre rader. Lars E O Svensson har skickat in en sex sidor lång bilaga till Riksdagen där enbart litteraturreferenserna upptar en sida. Och det är svidande kritik som framförs. Svensson anser att den penningpolitiska redogörelsen till riksdagen är ofullständig och missvisande och analys och viktiga fakta saknas:

    ”Måluppfyllelsen för penningpolitiken är för närvarande dålig eftersom inflationen är långt under målet och arbetslösheten är högt över en rimlig långsiktigt hållbar nivå”, skriver Lars E O Svensson i sin reservation.

    Som så många gånger förr pläderar vice Riksbankschefen för en lägre styrränta och han ser mycket små risker för att det ska leda till en oroväckande skuldsättning bland hushållen. Istället skulle en mer expansiv penningpolitik ha medfört en betydligt lägre arbetslöshet i Sverige, enligt Svensson.”

  2. “Krav på ytterligare mål för Riksbanken
    Både inflation och arbetslöshet I en färsk prognos skriver Konjunkturinsitutet att arbetslösheten i Sverige kommer ligga kvar på runt höga 8 procent i flera år framöver. Nu kräver allt fler politiker och ekonomer att Riksbanken lägger till ett mål om lägre arbetslöshet.”

  3. I would also think that a proviso to targeting anything are that one, it’s effects are clearly understood both in the aggregate and in terms of structure and two, the thing you are targeting can be measured reasonably accurately and in a timely manner.

  4. ’’I, together with some old-fashioned, but progressive, economists, like to emphasize that the concerns of Keynes and
    the Stockholm School are not dead. It is not enough to cut public expenditure and
    save more, as the younger generation of liberal Swedish economists seems to think.
    The resources that are freed in the process
    must find productive employment in an expanding economy and be matched by increasing aggregate demand.The
    whole world is suffering from the great evil
    of underutilized resources, high under-emloyment and poverty. In this context,
    there is need for a global Keynesian approach. The high unemployment rates in the
    OECD countries, which are at the root of
    the imminent dangers of protectionism,
    nom are ultimately the effects of too low a level
    of effective demand.’’
    Erik Lundberg 1981

Sorry, the comment form is closed at this time.

Blog at
Entries and Comments feeds.