“Inflation on demand”

The title was inspired by Olivier Blanchard´s presentation at the Brookings gathering on January 8 on “Should the Fed stick with the 2% inflation target or rethink it”.

Blanchard proposes increasing the target to 4%. He also comments that Bernanke´s recent “temporary price level targeting”, which Blanchard calls “inflation when you need it”, so that real interest rates can be lowered when you are at the ZLB. That´s “Inflation on demand”!

In addition to a higher inflation target, the Brookings gathering also discussed an inflation band (Rosengren), a price level target (John Williams) and nominal GDP targeting (Jeffrey Frankel).

After experiencing more than 30 years of low inflation and a quarter century of low and stable inflation, I find all the talk on inflation “absurd”. It is even stranger that now the talk is about raising inflation!

Greenspan´s objective was to keep inflation “low”, where “low” was that inflation that people didn´t notice. Six years ago, “low” was precisely defined as 2%. With that, the problems began, because the target was never (until now, at least) reached.

However, even before the 2% target was explicitly established in January 2012, when Bernanke took over the Fed in January 2006 everyone new that he was an inflation target freak (@2%). I am reminded of James Meade´s alert 40 years ago in his Nobel Lecture, that the pursuit of price stability (here defined as 2% inflation) is dangerous:

Earlier I spoke of ‘price stability’ as being one of the components of ‘internal balance’. Yet in the outline which 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 dangerousIf 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?

This was exactly what happened in 2008. Bernanke didn´t look through the 2007-08 oil shock, which increased inflation, especially the headline PCE, and tightened policy. Although the Fed Funds rate was coming down, monetary policy, the stance of which is better gauged by NGDP growth relative to trend, was being tightened and after mid-2008, the monetary screw was tightened further, with NGDP growth tanking.

The charts illustrate.

There´s a natural experiment here. Note that there were two back-to-back oil shocks of comparable magnitude. The first in 2004-06 happened mostly under Greenspan. Note that at that time, NGDP growth remained stable. In the second shock, under Bernanke, NGDP growth falls significantly before tumbling into negative territory.

In Bernanke´s case, the NGDP drop was motivated by the surge in headline inflation. A BIG mistake.

More generally, in the charts below you can see that prior to 2006, price level targeting and NGDP level targeting (and also core inflation targeting) were observationally equivalent.

When NGDP fell significantly below the trend level path, the economy deteriorated, indicating that de facto NGDP level targeting was what was providing Nominal Stability, a concept more encompassing than Price Stability.

As James Meade also said in his 1977 Nobel Lecture linked to above:

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.

I hope the Fed under Powell will end up choosing an NGDP Level Target as the new monetary framework.


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