The Poisoned Chalice of Macroeconomic Policy

The Eurozone experienced a second recession in 2011-2012, just a few years after the first one in 2008-2009. This second downturn was the fatal blow that turned Europe's Great Recession into an outright depression. The standard explanation for the emergence of this second recession is the sovereign debt crisis and the increased fiscal austerity in the Eurozone periphery that occurred during this time. Is this understanding correct?

Paul Krugman says no in  a new post. He points, instead, to the ECB's raising of interest rates twice in 2011 as the cause of the second recession. I agree with Krugman. This explicit tightening of monetary policy in the Eurozone, when many of its countries had to yet to fully recover from the first recession, increased the debt burdens and gave austerity its teeth. These latter developments had an effect on the Eurozone economy, but that they were more a propagating mechanism than the initial shock. I have a new Mercatus paper coming out soon that provides extensive empirical support for this view. So I am glad to see Krugman restart the conversation on what went wrong in Europe. The Eurozone Crisis was the Lords of Finance all over again.

One question that Krugman does not address in his post is why the ECB chose to raise interest rates at this time. This, in my view, is an important question because it speaks to one of the two big shortcomings of inflation targeting that has led me to conclude its time as a monetary regime has come and gone. Unless we wrestle with inflation targeting's shortcomings, I am fairly confident we are gong to see central banks continue to repeat the ECB's mistakes in the future. To that end, I want to briefly review these shortcomings below. 

Shortcoming One: Divining the Movements in Inflation

The first shortcoming of inflation targeting is that central bankers must discern in real time whether changes in inflation are caused by demand shocks or supply shocks. This is an almost impossible task that requires an herculean ability to divine developments in the economy.

Ideally, central bankers should only respond to demand shocks since they originate from changes in monetary conditions. Moreover, they push inflation and output in the same direction so it is easy for central bankers to respond to them. For example, if banks create excess money and cause inflation and real activity to grow too fast, a central banker can respond in a helpful manner by tightening monetary conditions. This will reign in both inflation and real GDP. The economy will stabilized. 

Supply shocks, on the other hand, come from fundamental changes to the productive side of the economy and cannot be fixed by monetary policy. Central banks should avoid responding to temporary changes in inflation caused by these shocks. For example, if an important input to production--like oil or labor--suddenly becomes more scarce it will temporarily raise inflation. Central banks may be tempted to respond to such inflation, but doing so will only make matters worse. For to reign in such changes in inflation means to further constrict an already weakened economy. But this is exactly what happened to the ECB in 2011. It raised interest rates in response to inflation caused by rising commodity price shock (negative supply shocks) which were already weighing on weakened economy. The ECB also raised interest rates in 2008 for the same reason.

This divining problem is pervasive to all inflation targeting central banks. Supply shocks were an issue in 2002-2004 for the Fed when the productivity boom at that time (a positive supply shock) put downward pressure on prices and caused the FOMC to worry about deflation. They should not have been worrying since aggregate demand was rapidly growing. Nonetheless, the Fed kept interest rates low even as the housing and credit boom started taking off. Supply shocks were also an issue in 2008 when Fed officials, like their ECB counterparts, were concerned about rising commodity prices (a negative supply shock) and were hesitant to lower interest rates. Consequently, the Fed failed to lower interest rates fast enough and helped create the Great Recession.

Along these lines, Ben Bernanke, Mark Gertler, and Mark Watson argue the reason sudden increases in oil prices (a negative supply shock) have historically been tied to subsequent weak economic growth is not because of the oil prices themselves, but because of how monetary policy responds to those shocks. That is, the Fed typically has responded to the inflation created by supply shocks in a destabilizing manner. With the advent of inflation targeting in the early 1990s, this problem has become institutionalized across most central banks.

Now in theory modern inflation targeting should be able to handle these shocks. For the modern practice is to do 'flexible inflation targeting' which aims for price stability over the medium term and therefore allows some wiggle room in responding to supply shocks. The problem, as noted above, is that in practice it often does not works. Responding to supply shocks in real time requires exceptional judgement and a lot of luck. Some researchers, in fact, believe inflation targeting was easier in the 1990s because central banks were luckier. There were fewer aggregate supply shocks with which central bankers had to contend. If this reading of history is correct, then it seems central bankers ran out of luck in the past decade.¹

Shortcoming Two: Responding to Large Demand Shocks  

The second shortcoming of inflation targeting is that it does not provide enough degrees of freedom for monetary authorities dealing with large demand shocks. This is both by design and by accident. The design part is that inflation targeting is a growth rate target, not a growth path target. By targeting the growth rate it does not make up for past mistakes. Therefore, if a large demand shortfall requires a temporary surge in inflation above 2% to restore full employment, the inflation target will prevent this from happening. 

To make this clear, here is an example from my FT article. Imagine the Fed decided at the end of the Great Recession in mid-2009 to return aggregate demand (NGDP) to its pre-crisis trend path.  Below is a figure from a paper of mine where I estimate what would have happened to core PCE inflation for three different recovery paths of NGDP:  a two-year path, a three-year path, and a four-year path. The first figure shows the three NGDP recovery paths and the second figure shows the inflation forecasts associated with these paths.

On all paths, inflation is notably higher than both the actual inflation rate that occurred and the actual 2% target rate. The inflation rate would get as high as 3.8% for the two-year path and 3.2% for four-year path. Over all counterfactual paths inflation would average around 2.5% since mid-2009, compared to actual average of 1.5%. This never was gong to happen with the Fed or the ECB.

Now, as noted above, flexible inflation targeting could in theory accommodate such temporary deviations in inflation. However, revealed preferences over the past seven years suggest in practice it is not possible. Central banks have been so good at creating low inflation since the early 1990s that it is now the expected norm by the body politic. Any deviation from low inflation is simply intolerable. In the US, everyone form the media to politicians to the average person start to freak out if inflation heads north of 2%. This mentality seems even worse in Europe. Inflation-targeting central banks, in other words, have worked themselves into an inflation-targeting straitjacket that has removed the few degrees of freedom they had. It is hard to imagine Yellen and Draghi being able to raise inflation temporarily above 2% in this environment. All they can do is operate in the 1-2% inflation window. Inflation targeting's success has become it own worst enemy.

Another way of saying this is that the space for doing macro policy has shrunk to the small window of 1-2% inflation. Not only is monetary policy constrained by this, but so is fiscal policy. This is why even helicopter drops will not make much difference, a point also made by Paul Krugman. 

For these reasons inflation targeting has become the poisoned chalice of macroeconomic policy. It was a much needed nominal anchor in the 1990s that helped restore monetary stability. Its limitations, however, have become very clear over the past decade and now is preventing the world from having the recovery it needs. This is why we need to learn the right lessons from these past seven years and Krugman's post is a step in the right direction.

As readers of this blog will know, my solution to the above problems is NGDP level targeting. It would get past the divining problem by having central banks focus on the cause (aggregate demand shocks) and not a potentially misleading symptom (inflation) of it. As a level target, it would also be up to the task of responding to large demand shocks. To make it credible, I have proposed it be automatically back-stopped by the U.S. Treasury. Until we see a monetary regime change along these lines, we will continue to drink from the poisoned chalice of macroeconomic policy.

¹I review this 'central bankers got lucky' argument in my inflation targeting critique paper.