Monday, November 14, 2016

There is another way to fight inflation, other than raising interest rates.

From Monetary policy at the time of elections by Silvia Merler at Bruegel:
Kenneth Rogoff says ... Given that the Fed may struggle just to get its base interest rate up to 2% over the coming year, there will be very little room to cut if a recession hits. The two best ideas for dealing with the zero bound (negative rates and higher inflation target) are off-limits for the moment. Of course, there is always fiscal policy to provide economic stimulus. But it is extremely undesirable for government spending to have to be as volatile as it would be if it had to cover for the ineffectiveness of monetary policy. There may not be enough time before the next deep recession to lay the groundwork for effective negative-interest-rate policy or to phase in a higher inflation target. But that is no excuse for not starting to look hard at these options, especially if the alternatives are likely to be far more problematic.

There is another way to fight inflation, other than raising interest rates. If policy makers adopt this new method and use it in addition to manipulating rates, getting the base rate up to 2% over the coming year may be sufficient. Without extra help, rates might need to be at 4 or 5%; but with the extra help, 2% may be enough.

This supplemental method of fighting inflation does not depend on interest rates. Therefore the zero bound is not an issue.

The supplemental method may be categorized as a type of fiscal policy, but it need not be volatile. Nor should it be.

Back when the crisis hit, monetary policy suddenly shifted from an anti-inflationary stance to an anti-deflationary stance. Why? Why was the goal to encourage inflation rather than to prevent it? Because everyone was deleveraging, and deleveraging is deflationary.

Policy makers have the option to use controlled deleveraging as a way to fight inflation.

There is occasional talk of eliminating the tax deduction for mortgage interest expense. The economy may still be far too fragile for that, but the motivation is clear: The tax deduction for mortgage interest encourages indebtedness. Essentially, accumulated private debt is greater than it would otherwise be, because of the tax deduction.

Suppose instead, policy offered a tax credit for accelerated repayment of mortgage debt. This policy would not encourage indebtedness. Just the opposite in fact. The tax credit could be designed to create a tax benefit that is equal to the existing tax deduction for mortgage interest. It could be revenue neutral. Then policy makers could replace the tax deduction with the tax credit without shocking the economic system.

With the accelerated-repayment tax credit in place, private debt would accumulate more slowly than at present. Debt repayment would be more rapid. The net effect would be to reduce inflationary pressures. Properly designed, accelerated-repayment should be a permanent part of policy, just as inducements to borrow are a permanent part of policy.

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