Monetary Policy Potpourri

  1. Monetary Policy Framework

Raphael Bostic, president of the Atlanta Fed has a three part (so far) series on Thoughts on a Long-Run Monetary Policy Framework.

His preferred framework is for the Fed to adopt price level targeting.

Bostic writes:

[f]ormer Fed chairman Alan Greenspan offered a well-known definition of what it means for a central bank to succeed on a charge to deliver price stability. Paraphrasing, Chairman Greenspan suggested that the goal of price stability is met when households and business ignore inflation when making key economic decisions that affect their financial futures.

I agree with the Greenspan definition, and I believe that the 2 percent inflation objective has helped us meet that criterion. But I don’t think we have met the Greenspan definition of price stability solely because 2 percent is a sufficiently low rate of inflation. I think it is also critical that deviations of prices away from a path implied by an average inflation rate of 2 percent have, in the United States, been relatively small.

Interestingly, as the chart shows, as soon as 2% target became explicit, the price level fell short of the target! In July 1996, when the FOMC discussed inflation targeting, and 2% was the “preferred number”, Greenspan alerted (page 72):

The discussion we had yesterday was exceptionally interesting and important. I will tell you that if the 2 percent inflation figure gets out of this room, it is going to create more problems for us than I think any of you might anticipate.”

A major problem with targeting the level of the headline PCE is that it is very volatile, being buffeted by things like oil shocks. The chart compares fluctuations in headline and core PCE.

Although the core PCE has progressed below the 2% trend path “forever”, before the 2% target became explicit no one bothered!

Instead of focusing on inflation, the Fed would have fared better if it had continued to keep nominal spending (NGDP) close to the trend level path. It would have “minimized” the disaster if, after letting nominal spending tank, it had resumed growth at the previous trend rate.

As Scott Sumner argues in The problem with central bankers’ inflation preoccupation:

High inflation is not a good indicator of the state of the economy, because it can either reflect excessive demand or a decrease in aggregate supply. In contrast, NGDP growth shows the increase in total spending in the economy — i.e. aggregate demand — and is an excellent indicator of whether the economy is overheating and needs monetary restraint.

In 2008, the Fed focused on the wrong indicator.

Inflation was distorted by soaring oil prices, and Fed policy during 2008 ended up being far too contractionary for the needs of the economy. As a result, NGDP fell by more than 3 per cent between mid-2008 and mid-2009, the worst performance since the 1930s.

A policy aimed at 4 per cent or 5 per cent NGDP growth would have likely led to above 2 per cent inflation during 2008-09, but that sort of problem is nowhere near as costly as 10 per cent unemployment.

  1. Immaculate Inflation & Inflation-Unemployment Link

Paul Krugman writes “Immaculate Inflation Strikes Again”:

[A]s Karl Smith pointed out a decade ago, the doctrine of immaculate inflation, in which money translates directly into inflation – a doctrine that was invoked to predict inflationary consequences from Fed easing despite a depressed economy – makes no sense.

In answer to comment, however, Karl Smith is more specific:

I haven’t put enough time into my posts to be very clear. I am apologize for that. However, my point is that whatever the ultimate cause of inflation, the proximate cause must be an increase in nominal demand or a decrease in supply.

As the nominal GDP chart above shows, the problem was a “permanent” drop in nominal spending (nominal demand).

Krugman then asks “Is there any relationship between unemployment and inflation?” And argues:

[T]he claim that there’s weak or no evidence of a link between unemployment and inflation is sustainable only if you insist on restricting yourself to recent U.S. data. Take a longer and broader view, and the evidence is obvious.

Consider, for example, the case of Spain. Inflation in Spain is definitely not driven by monetary factors, since Spain hasn’t even had its own money since it joined the euro. Nonetheless, there have been big moves in both Spanish inflation and Spanish unemployment.

“Definitely not driven by monetary factors…?” It´s always “risky” to discard monetary causes for inflation, even if, like Spain, the country is subject to “outside” monetary policy.

The panel below shows that unemployment patterns in Spain and the US are the same, and linked to what´s happening to NGDP (i.e. monetary policy).

Note that NGDP contracted much more strongly in Spain, with unemployment jumping higher.

Note also that unemployment begins to fall in both countries when NGDP stops falling and initiates a rising trend. The timing is significantly different in the two countries. Remember that in the EZ, Trichet applied the monetary screws once again in April and June 2011, with improvement only beginning after Draghi took over and promised “whatever it takes”. Meanwhile, in the US the Fed started QE in March 2009.

Krugman is definitely wrong. And while the Fed seems intent on guiding monetary policy by what´s happening to the unemployment rate, “success” will be elusive.


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