Friday, October 8, 2010

What Do John Cochrane and Milton Friedman Have In Common?

Yes, they are both well-known economists from the University of Chicago, but there is more.   Milton Friedman in the early 1990s called for the Federal Reserve to start targeting the expected inflation rate implied by the difference between the nominal treasury yield and the real TIPs yield.  He made this call in his book Monetary Mishief.* Now John Cochrane is advocating this approach too:
[T]he Fed can target the thing it cares about – expected CPI inflation – rather than the price of gold.  To do it, the Fed can target the spread between TIPS (Treasury Inflation Protected Securities) and regular Treasurys, or CPI futures prices.  Here’s a simple example. Investors buy a CPI-linked security from the Fed for $10.  If inflation comes out to the Fed’s target, they get their money back with interest,  $10.10 at 1% interest. If inflation is 2 percent below target, the Fed pays $2 extra -- $12.10.  This pumps new money into the economy, with no offsetting decline in government debt, just like the helicopter drop. If inflation is 2 percent above target, investors only get back $8.10 – the Fed sucks $2 out of the economy at the end of the year.  If investors think inflation will be below the Fed’s target, they buy a lot of these securities, and the Fed will print up a lot of money, and vice versa.
I am thrilled to see a prominent economist like John Cochrane promoting this forward-looking approach to monetary policy. Had the Fed had such a target in place in 2008 it would have seen a drop in inflationary expectations well before Lehman's crash.  But it did not and, as result, it sat passively by and allowed an effective tightening of monetary policy during 2008

Of course, I would like the Fed to do one better and adopt a forward-looking NGDP target.  A foward-looking NGDP target would be more effective because the NGDP target focuses on that which the Fed has influence: nominal spending.  A forward looking inflation target may at times lead the Fed to respond to more than just nominal spending shocks.  This is because movements in inflation can reflect both aggregate demand and aggregate supply shocks. Macroeconomic stability requires the Fed only respond to former and ignore the latter.  With that said, I am happy to see John Cochrane pushing this debate in the right direction.  

(Hat Tip: Scott Sumner)

*The idea for targeting the expected inflation rate implied by TIPs originated with Robert Hetzel.  Interestingly, he too is a product of the University of Chicago.


  1. Cochrane's actual proposal here seems closer to my 1989 NGDP future targeting idea, than to Hetzel's 1989 TIPS spread targeting idea. Except he uses the CPI instead of the NGDP. Also, you need to have the money supply change right away in response to these transactions, not a year later after they mature.

  2. Excellent blogging. Keep up the good wrok