Monday, September 27, 2010

More Inflation Yes, Inflation Targeting No!

Scott Sumner has two new posts up that speaks to something that has been bugging me lately: the increasing popularity of an explicit inflation target for the Fed.   Many bloggers, including myself, have been calling for the Fed to create more inflation or at least stabilize inflation expectations.   I have been particularly vocal on the latter point.  Others have been  more forceful in their call for an explicit inflation target as a means to increase the inflation rate.  All along, my reason for arguing for the Fed to stabilize inflation expectations is that doing so would indicate the Fed is stabilizing expectations of future  aggregate demand (given that productivity does not appear to be contributing to drop in inflation expectations).  Such actions, in turn, would also serve to stabilize current aggregate demand as  well.  

Now, I have never been enthusiastic about stabilizing inflation as an end in itself.  The reason being is straightforward: inflation is a symptom, not an underlying cause.  More generally,  the percentage change in the price level could be the result of shocks to  aggregate demand (AD), aggregate supply (AS), or both.  Currently, it seems clear that the drop in inflation expectations and the drop in core inflation are reflecting faltering aggregate demand.  Thus, it makes sense to talk about the need to arrest these drops.  However, it need not always be the case--low inflation could also be the symptom of a positive AS shock (e.g. productivity boom).   Imagine, for example, aliens land and give us new technology that makes our computers faster, gives us clean energy, and allows us to travel to  distant galaxies.  Such an alien encounter would create mother of all productivity booms.  Among other things, this productivity boom would imply a higher neutral interest rate, lower inflation rate, and robust AD growth (given  the increase in expected future income).  In such a case a rigid inflation target of say 4%, as some have proposed, would not make  sense here.  Most likely it would be too high an inflation rate to keep AD stable.   

Another way of saying all of this is that monetary policy should focus only on that over which it has meaningful control:  total current dollar spending or AD.  It should ignore AS shocks, both the good and the bad, because all it can do by responding to such shocks is to make matters worse  as alluded to above.   Focusing too narrowly on an inflation target--which assumes every shock is an AD one--can cause a central bank to make this very mistake.  I made this case before in  more detail in this post which got some play time in the economics blogosphere (e.g. Mark Thoma reposted it here).  My hope was that this post would help folks see that the stabilization of AD rather than inflation targeting should be the key  objective of monetary policy. 

So what kind of monetary policy would serve to consistently stabilize AD?  The answer is one that directly targets a stable growth path for AD. This could be a NGDP target or a final sales of domestic output target or any measure that directly aims to stabilize the growth of total current dollar spending.  Scott Sumner outlines its advantages in a recent post, but let me add a few thoughts.  First, an AD target is easy to implement.  All it requires is a measure of the current dollar value of the economy.  It does not require debates over the proper inflation measure, inflation target, output gap measure, and coefficient weights that plagued inflation targeting and the Taylor Rule.  Second, it can easily be made into a forward-looking rule by having the Fed targeting the market's forecast of AD.  This would require some innovations such as  NGDP futures market, but it is within the realm of possibilities as shown by Scott Sumner.  Finally, it could be easily communicated to and understood by the public by labeling it along the line of a "total cash spending target." 

Let me end by noting some of the famous observers who have called in the past for some form of AD targeting: Bennet McCallum, Greg Mankiw, Robert Hall, Menzie Chinn, Jeffrey Frankel, Martin Wolf, Samuel Brittan, and Frederick Hayek. I like this crowd, how about you?

Update: Karl Smith replies to Scott Sumner and me on this issue.  One point Karl brings up is the possibility that a NGDP target could increase macroeconomic instability.  Bennett McCallum addressed this issue a while back and showed that this need not be the case if there is forward looking behavior.  More recently, Kaushik Mitra showed that even with adaptive expectation-type behavior NGDP targeting can work well. 

10 comments:

  1. Excellent commentary, really superb.

    I do wonder about "the public."

    As the risk of sounding horribly elitist, I am not sure "the public" cares much about technical labels, or even knows who is Ben Bernanke. I wonder if they even remember who is Joe Biden (he has disappeared, btw).

    That being the case, somewhat mushy statements like "The Fed is more concerned about growth now," may be what the public needs to hear.

    I like the sentence, "The Fed is becoming more monetarily bullish," or "the monetary bulls have become more influential inside the Fed."

    Back monetarily bullish sentence up with $100 billion a month of QE, and the other measures Sumner advocates.

    The phrase "total cash spending" might be seized and warped by critics who will say you are just running the printing presses, not doing the hard work of structural improvements and tax cuts.

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  2. DB: So you come down perhaps more on the side of the deficient AD side of the increasingly acrimonious debate between Krugman and the Canadians (Andolfatto/ Williamson) about the nature of US unemployment. Seems like positions are hardening, and people getting locked into all-or-nothing statements - its either all cyclical or all structural. Surely there are elements of both, but I guess bloated egos prevent the bigger names from agreeing to that.
    Spain and Ireland had the worst housing bubbles over the period 2001-2006, and they have been hit as hard as the US. So it does seem like US unemployment will remain elevated unless policy addresses housing. Krugman calls for more stimulus don't get at this problem.

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  3. ECB:

    On balance I see AD as more important, but yes I also see structural issues as well. That there are structural problems seems obvious to me. I mentioned before that the Fed cannot solve all of our problems--since many are structural--but it can create more macro economic certainty (with an explicit nominal target) and stabilize AD from faltering anymore.

    The big structural issue I see is the decimated household balance sheet. It seems to be the core of most other problems. More easing by the Fed won't cure this problem, though it would marginally help. Here is where we need some radical change like a debt for equity program.

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  4. The only problem with shifting the attention to AD is the problem that has abided for the past several years--the Fed has lousy aim.

    I'm still arguing for higher inflation targeting (would certainly accept concentration on AD instead) because it highlights the current bollix of the Fed--if they are really targeting a 2.0-2.5% inflation rate, their ability to hit the broad side of a barn isn't in doubt; it's whether they're even on the right property.

    The world we would like to live in is well-described by your post (and, as noted, I agree it would probably produce better results if the entity were capable of following it). The issue that abides is that the Fed's inability to target inflation (which is relatively easier to quantify than an optimal level of AD) suggests strongly that a shift to the theoretically-better metric will be met with abject failure.

    It would be as if you tried to "stimulate" the economy by a combination of poorly-planned tax cuts and producing just enough additional monies on the Federal level to offset a decline in State and Local production: people would come to believe that "stimulus" doesn't work.

    A shift to AD certainly needs to be considered. But it should be done officially after the economy recovers, when the appropriate plans and organization can be put in place. Until then, the fault lies in ourselves, and a good idea at the wrong time likely will be worse than a bad one, since it will be discredited for all the wrong reasons.

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  5. Ken,

    That's a fair point. Karl Smith argues something similar here:http://modeledbehavior.com/2010/09/27/ngdp-targeting-a-response-to-sumner-and-beckworth/

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  6. "However, it need not always be the case--low inflation could also be the symptom of a positive AS shock (e.g. productivity boom)."

    I'm going to add to that and ask if cheap labor and positive productivity growth produce price deflation, what should happen?

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  7. "Focusing too narrowly on an inflation target--which assumes every shock is an AD one--can cause a central bank to make this very mistake."

    So you are disagreeing with ben bernanke?

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  8. Can an aggregate supply shock that is not handled correctly show up as an aggreagte demand shock later?

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  9. "Finally, it could be easily communicated to and understood by the public by labeling it along the line of a "total cash spending target.""

    What if there are enough budgets impaired because of negative real earnings growth that the lower and middle class public can't spend enough?

    By cash, do you mean currency, the demand deposits created from debt, or both?

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  10. ecb said: "The big structural issue I see is the decimated household balance sheet. It seems to be the core of most other problems. More easing by the Fed won't cure this problem, though it would marginally help. Here is where we need some radical change like a debt for equity program."

    Make that the household balance sheet of the lower and middle class but not the rich. Yep!

    It seems to me the fed does not care because they believe wage growth for the lower and middle class means price inflation growth(don't you remember the 1970's) and lower corporate profits.

    Is there something wrong with either about 52 trillion in debt or 58 trillion in debt and only about 1 trillion in currency?

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