Target the Cause Not the Symptom

Olivier Blanchard of the IMF recently made the case for monetary policy targeting a 4% inflation target instead of the standard 2% target. His main argument for doing so is that it would make the zero bound on the policy interest rate less of an issue. Here is how the Wall Street Journal summarized his view:

At a 4% inflation rate, Mr. Blanchard says, short-term interest rates in placid economies likely would be around 6% to 7%, giving central bankers far more room to cut rates before they get near zero, after which it is nearly impossible to cut short-term rates further.

There was a lot of push back on this argument in the blogosphere from folks like Ryan Avent, Mark Thoma, and David Altig who countered that (1) the zero bound isn't really a constraint for monetary policy, (2) higher inflation will lead to increased relative price distortions, and (3) there is mixed evidence and thus less certainty on the benefits of higher inflation. While all of these points are valid, I think there is a more fundamental problem with Blanchard's view: inflation targeting at any rate is merely responding to the symptom not the underlying causes--shocks to aggregate demand (AD) and shocks to aggregate supply (AS)--of macroeconomic volatility. This is problematic because monetary policy can only meaningfully counter AD shocks and therefore, it must be able to discern which shock is driving inflation. Inflation, however, can be hard to interpret. For example, if there is a sudden burst of inflation is it due to a positive aggregate demand shock (e.g. sudden, unsustainable increase in household spending) or a negative aggregate supply shock (e.g. temporary spike in oil prices)? In the former case inflation targeting would act appropriately by reigning in excess spending while in the latter case inflation targeting would only make matters worse by further restricting economic activity. Rather than targeting inflation, then, monetary policy should directly target the underlying source of macroeconomic volatility over which it has real influence, AD. Doing so would have gone a long way in making the U.S. economy during the 2000s more stable, a point I have made repeatedly during this crisis.

The importance of targeting AD can easily be illustrated using an AD-AS model. Here I use the AD-AS model developed by Tyler Cowen and Alex Tabarrok in their new macroeconomic textbook. Their version of the AD-AS model places growth rates on the two axis rather than levels. Below is the model in equilibrium with an AD growth rate of 5% that can be split up into an inflation rate of 2% and a real growth rate of 3%. (Click on figure to enlarge.)

Now consider four shocks to the economy when monetary policy is solely targeting an inflation rate of 2%. First, let see what happens when there is a positive AD shock driven by say expansionary fiscal policy (click on figure to enlarge):

The positive AD shock pushes the economy beyond full employment, increases inflation to 3%, and real growth jumps to 4%. AD is now growing at an accelerated rate of 7%. Fed officials seeing the higher inflation tighten monetary policy to get back to 2% inflation and in so doing push the economy back to full employment. Here the 2% inflation target worked just fine and effectively served to stabilize AD at 5% growth.

Now consider a negative AD shock caused by say a sudden collapse in economy certainty (Click on figure to enlarge).

The negative AD shock causes inflation to fall and turn into -2% deflation while the real growth rate falls to -3 real growth rate. AD is now at a -5% growth rate. Fed officials see the deflation and loosen monetary policy to get back to 2% inflation. In so doing they push the economy back to full employment. Here again, the 2% inflation target worked fine and effectively served to stabilize AD at 5% growth. Scott Sumner argues this type of shock was behind the Great Nominal Spending Crash of late 2008, early 2009. If so--I buy his argument--then inflation targeting would have done wonders during this time for the Fed.

So far inflation targeting is doing its job. But so far we have only encountered AD shocks. How well will inflation targeting work with AS shocks? Consider first a negative AS shock due to say a temporary disruption of the oil supply. Given the temporary nature of the shock, the short run AS (SRAS) curve would shift left.

The negative AS shock causes inflation to increase to 3% and slows down real growth to 2%. Under pure inflation targeting, Fed officials would see the pickup in inflation and respond by tightening monetary policy to bring inflation down to 2%. As the second figure above shows, though, such a response would slow AD to a 2.5% growth rate and only further weaken the economy. A far better response would have been to do no harm by keeping AD stable at 5% growth. AD would still be growing at 5% and given the temporary nature of the negative AS shock, the economy would eventually return to full employment. Inflation targeting fails to stabilize here.

Now consider our final scenario: a permanent positive AS shock due to say an major improvement in technology (i.e. positive productivity shock). This shock would cause LRAS to shift right.

The positive AS shock causes inflation to drop to 1%, but increases real growth to 4%. Fed officials see the drop in inflation and respond by loosening monetary policy to bring inflation back to its 2% target. Doing so, however, increases AD to a 7% growth rate which pushes the real economy beyond full employment to an unsustainable 5% growth rate. Here too, a far better response would have been to do no harm by keeping AD stable at 5% growth. Such a response would keep the economy at full employment instead of entering a boom-bust cycle. Once again, inflation targeting fails to stabilize in response to an AS shock. Note that this positive AS shock creates benign deflationary pressures which are different than the malign deflationary pressure created by the negative AD shock above. This distinction helps us understand the difference between the deflation scares of 2003 and 2009.

So what are the main takeaways from this analysis? First, inflation targeting is only effective when AD shocks are the main source of macroeconomic volatility. If AS shocks are also important,then inflation targeting can be destabilizing. Second, a far more effective approach to minimizing macroeconomic volatility is to stabilize AD. In the above scenarios, stabilizing AD growth around a 5% target was all that was needed.

An obvious critique of the above analysis is that the Fed does not only aim to stabilize inflation but also looks at the output gap given its dual mandate for price stability and full employment. And there is ample evidence that the Fed has done this to some extent by implicitly following a Taylor Rule. Josh Hendrickson even shows the Fed during the Great Moderation effectively targeted AD. While all of this is true, it is also true that the Fed does not explicitly follow the Taylor Rule and has used this flexibility to deviate from it at certain times in a manner that is consistent with pure inflation targeting. Stated differently, in such times the Fed has been more likely to err on the side of stabilizing inflation than stabilizing AD. For example, during the deflation scare of 2003 of the Fed acted more like a pure inflation targeter--it aimed to stabilize inflation even though there was evidence of rapid productivity gains pushing down the inflation rate rather than it coming from a weakening economy--and as a result AD growth at that time was anything but stabilized. A more fundamental problem with this critique is that the Fed has simply failed too many times to stabilize AD. Case in point is the Great Nominal Spending Crash mentioned above where AD had its largest decline since the Great Depression of the 1930s.

The bottom line is that monetary policy should target the cause not the symptom of macroeconomic volatility over which it has control. Olivier Blanchard's proposal does not do that. If anything, it would only serve to make the Fed even more focused on the symptom, inflation, at the expense of stabilizing the cause, AD.