Only inflation on their minds

Summary of new research: Fed Could Allow Higher Inflation as Interest Rates Remain Low, Papers Suggest:

U.S. interest rates are likely to stay historically low, which should prompt the Federal Reserve to rethink its approach to inflation. Those are the conclusions of two new research papers by teams of Fed economists published Thursday by the Brookings Institution.

Taken together, the two papers conclude that increased demand for safe and liquid assets such as 10-year Treasury notes will continue to hold down yields, making it difficult for the central bank to raise its benchmark short-term interest rate while sticking to its 2% annual inflation target. One response would be to allow higher levels of inflation.

(the papers: 1, 2)

In the same vein, Tony Yates writes, “Re-specifying the inflation target for low real interest rates”:

The Fed’s John Williams has commented that the Fed should revisit the inflation target to provide for future episodes in which very low interest rates are needed.

This is welcome.  Blanchard, Krugman, and many others have made the same argument [7 years ago].

A higher target would lead to the resting point for central bank rates rising one for one, roughly, (risk premium calculations aside) making more room for interest rate cuts when the Fed next has to deal with a recession.

It´s a dead end! For at least a quarter century, inflation has not been a problem. The problem has been the total concentration on inflation. It is a dangerous obsession. The view was clearly stated 40 years ago by James Meade in his 1977 Nobel Lecture:

Earlier I spoke of ‘price stability’ as being one of the components of ‘internal balance’. Yet in the outline that I have just given of a possible distribution of responsibilities, no one is directly responsible for price stability. To make price stability itself the objective of demand management would be very dangerous.

If there were an upward pressure on prices because the prices of imports had risen or because indirect taxes had been raised, the maintenance of price stability would require an offsetting absolute reduction in domestic money wage costs; and who knows what levels of depression and unemployment it might be necessary consciously to engineer in order to achieve such a result?

The “X-Ray” below provides a nice view of the economic patient. In the second half of the 1960s, inflation took an upward tilt, just as nominal spending (NGDP) growth trended up. Inflation spikes occurred when oil shocks materialized. At those times, as could be expected, real growth recoiled.

Disinflation occurred when nominal spending growth was rein in. A period of low and stable inflation followed, determined by a stable growth of nominal spending.

More recently, in 2008, an inflation-obsessed Fed allowed nominal spending growth to tank. Spending growth never fully recovered, keeping real growth in a depressed state. The low but stable nominal spending growth has kept inflation also (excessively) low and stable.

Mistakenly, the researches and some Fed members think that to allow interest rates to rise, the inflation target has to increase. They miss the point completely. Interest rates will only rise if nominal spending growth increases.

That was also clearly seen by James Meade:

Later in the Lecture he proposes NGDP Level Targeting (and even considers the “monetary offset”):

I have told this particular story simply to make the point that the choice between fiscal action and monetary action must often depend upon basic policy issues, which should certainly be the responsibility of the government rather than of any independent monetary authority.

Perhaps the best compromise is an independent monetary authority charged so to manage the money supply and the market rate of interest as to maintain the growth of total money income on its 5-per-cent-per-annum target path, after taking into account whatever fiscal policies the government may adopt.

By wrongly associating the level of interest rates with the stance of monetary policy, the Fed is now set to do further economic damage by increasing the Fed Funds rate while keeping nominal growth depressed.

As justification, the Fed appeals to its double mandate and says that inflation is (finally) converging to the 2% target, which is an exaggeration, and that the low rate of unemployment indicates a “fully-employed” economy.

The chart shows that the low unemployment rate at present is meaningless, being almost exclusively dictated by the drop in labor force participation. But that, according to many, is the result of structural (demographic) factors over which monetary policy has no sway. A nice cop-out!

As Benjamin Cole put it some years ago: “It´s as if suddenly in 2008, the large and diverse USA lost its ability to grow. People lost the will to work, inventors got stupid, infrastructure clogged.”

Question: Would a better monetary policy improve labor market conditions and increase the LFPR?


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