Opinion – Cecilia Machado: The inflation target and expectations

There are some economic relationships that are not immune to changing public policy. This means that it is fallacious to infer the consequences of a policy change based on historical or intuitive patterns, as when arguing that a higher inflation target will allow interest rates to fall.

In other areas of knowledge this does not happen. Take the case of building a bridge. In this case, engineers take into account gravity, material resistance, soil and surrounding conditions, and know exactly what type of vehicle can circulate on the bridge and what they must do to operate it safely. The construction of the bridge in no way alters the action of gravity. But in economics, building the bridge (that is, changing the target) is capable of altering the law of gravity (the relationship between interest rates and inflation). How can things be so different in economics?

In large economic policy interventions, as in the case of raising the inflation target, it is reasonable to expect them to affect the way people make their decisions on a day-to-day basis. It is these changes in behavior and changes in the formation of expectations that make the relationship between economic variables not invariant to a new policy. Disregarding that people assimilate the implications of a policy change in their decisions, according to what is best for them, is very naive. Or else it reveals ignorance of a result that was incorporated into the macroeconomic framework more than 50 years ago.

In his studies carried out from the 1960s onwards, Robert Lucas challenged common sense and established that changes in behavior and expectations must be taken into account when formulating policies. Lucas’ Critique, as the argument defended by him came to be known, revolutionized the way economists work in the area. Lucas received the Nobel Prize in Economics in 1995 for his contributions to science.

However, despite this result being widely known, Lucas’ Critique seems to be being ignored in the discussion that now takes place about a possible increase in the inflation target. The increase in the target, which was introduced into the public debate by the political class (and not by technical criteria) and which has been reflected by the media in in-depth analyses, is a classic case in which Lucas’ criticism applies.

It is even intuitive to expect that an increase in the inflation target will make room for a reduction in interest rates: if we tolerate higher inflation, monetary policy may yield and impose less costs on the activity. Considering that the new inflation expectations are established in the new target —the best scenario that can be expected—, it is possible that there will be some room for the reduction of interest rates.

However, there is also a chance that expectations about future inflation will change differently. The precedent of changing the target now makes it credible that it will be revised again in the future. More than that, the modification of targets due to political considerations, or at times of high inflation, in which expectations are already above the target, or when technical decisions by the monetary authority come to be questioned, reveal little willingness on the part of society and the class policy with the arduous task of controlling inflation.

These two factors make ordinary people, such as businessmen and workers, understand that future inflation will be above the new target stipulated in price and salary readjustments. With higher expectations, the same nominal interest generates a lower real interest compared to the scenario where expectations converge to a new target. In other words, the deterioration of expectations makes the same level of interest less contractionary. Thus, it is conceptually possible that nominal interest rates need to rise to bring inflation to the new higher target.

These effects do not seem to be mere intellectual curiosities or particular cases of stylized models that are detached from our reality. The recent case of Argentina at the end of 2017 shows that a thoughtless increase in the target had perverse consequences for the country’s economy. The immediate consequences of the increase in the target and a small reduction in interest rates were a substantial increase in inflation expectations, a sharp exchange rate depreciation and a violent acceleration of the inflation rate itself.

Evidently, the shortcut did not work: soon after, the central bank itself found itself in need of raising interest rates and it is possible to say that even today Argentina suffers the consequences of that mistaken, albeit well-intentioned, decision.