In a blog post today, Paul Krugman outlines a hypothetical situation that we could find ourselves in:
And this raises the specter what I think of as the price stability trap: suppose that it’s early 2012, the US unemployment rate is around 10 percent, and core inflation is running at 0.3 percent. The Fed should be moving heaven and earth to do something about the economy — but what you see instead is many people at the Fed, especially at the regional banks, saying “Look, we don’t have actual deflation, or anyway not much, so we’re achieving price stability. What’s the problem?”
I wonder if, on a particularly lazy day when Paul Krugman finds it difficult walk upstairs, he claims that he is in the “main floor trap”? But I digress. There is only one culprit in this situation: the dual mandate.
I’m not an expert on the history of the dual mandate, but I would venture a guess that it was the result of a grand bargain in which “price stability” came from the “hawkish” right, and “unemployment” came from the “dovish” left. The nature of the Fed’s dual mandate is such that it allows the central bank to wiggle out of nearly any situation if finds itself in with little consequence. Since the Fed is aiming at two diametrically opposed targets at once (price stability and full employment), it has large discretion upon which it can draw to justify its policy actions.
Is unemployment 9.5% with core CPI inflation falling below 1% and future expected inflation well below target as well? Well, that’s price stability!
How about persistent inflation rates bordering on double-digits while employment booms? Pat yourselves on the back guys!
In reality, and much to the chagrin of leftists everywhere, the modern Fed (1980′s+) has mostly erred on the side of price stability, which in the recent context has meant 5% NGDP growth with a rough average of 3% real growth and 2% inflation. This has allowed for a NAIRU of around 4-5% for the United States as a whole. Of course, that is a rate…and as long as the unemployed are continually in flux — that is, as long as hires outpaces quits and fires — that rate isn’t much of a problem. What is a problem is that the same dual mandate that was praised by some economists during the Great Moderation is now enabling the Fed to shirk its duties (and perhaps even worse, providing cover for “leveling down” with an implicit policy of opportunistic deflation…which is what Krugman implies above).
The Federal Reserve’s mandate is unique in the world. Most other central banks operate under a “hierarchical mandate” which generally stipulates an inflation target. It is hierarchical, because the central bank can set any target other targets it wants, and pursue them in order as long as they have hit their mandated target. The results of this kind of target vary from country to country.
In my opinion, Congress should scrap the Fed’s dual mandate, and instead mandate that the Federal Reserve set an explicit nominal target, and do everything in their power to hit that target (level targeting). If they’re feeling generous, they can give the Fed discretion as to which target they would like to set. If not, I would specify NGDP. I don’t think that the monetary policymaking body of the Federal Reserve should even look at a single unemployment number. They should focus like a laser on their keeping their nominal target in a very narrow range and leave the question of unemployment (which is a real variable) to other policymakers.
Stabilize monetary policy around a nominal aggregate, and I would wager that unemployment would find a way to work itself out with minimal intervention.
P.S. I kind of smile when I think about the Fed “moving heaven and earth to do something about the economy”. I suppose that is because 1) I think that monetary policy can do so and 2) I’m a huge nerd.

3 comments
Comments feed for this article
Thursday ~ August 12th, 2010 at 12:24 pm
Leigh Caldwell
I’ve been thinking recently about how expectations are formed, and I wonder about the following scenario:
Let’s say the Fed does adopt an NGDP level target with a 5% annual increase, and this becomes accepted as the new orthodoxy. How will future wage negotiations proceed?
As an employee, I’d say to management: presumably you are good managers, and you expect to achieve growth in the company’s revenues, profits and productivity at least in line with the economy as a whole. (I’ve yet to meet a manager who’d admit that they are not as good as the national average manager).
Therefore, you’d expect your top line revenues to increase by at least 5%, given a fixed amount of labour in your company. What’s more, now that the Fed has successfully achieved a 5% NGDP increase for the last three years, I can confidently expect my cost of living, based on my reasonable expectation of a rising living standard, to increase by about 5% each year.
I would therefore suggest that my salary should incorporate a fixed 5% escalation every year from now on. What do you say?
This may or may not be the scenario that plays out in reality, and the negotiating skills of management and employees will vary. But it’s at least plausible that a 5% annual increase will become the new standard of nominal wage rigidity. And the next step may well be a standard 5% annual price increase, at least for products and services where there are no major productivity increases taking place. If so, then we are back in a situation of sticky nominal wages and prices – it’s simply a sticky 5% increase instead of a sticky 0% increase.
If this happens, will the benefits of the steady upward NGDP path disappear? Will we end up back in the same situation as the last few decades – where the policy target broadly achieves balanced growth for eight years and then we get a two year recession when investors become overconfident and it fails?
Maybe not – perhaps there is something psychologically special about 0% increases – but I am not so sure.
I’m still a supporter of the Sumner proposal, but I raise this as a cautionary question. In short, is any policy target bound to lose its effectiveness once people learn to expect it?
Thursday ~ August 12th, 2010 at 7:14 pm
Anonymous At Work
You wrote:
“P.S. I kind of smile when I think about the Fed “moving heaven and earth to do something about the economy”. I suppose that is because 1) I think that monetary policy can do so and 2) I’m a huge nerd.”
You forgot to add:
“…except at the zero bound.”
Inflation at almost 0.0% and interest rates almost at the same place. Not much conventional that can be done.
As a second comment, I think the modern love-affair with price stability that the current Fed has can trace its roots to Volker’s chairmanship, but wonder also what, if any, effect that most members are banking technocrats has? (Note: I have no issue with technocrats in technocratic positions; just need to be clear that they are such positions, as opposed to policy-setting ones.)
Friday ~ August 13th, 2010 at 9:16 am
Matthew Yglesias » Endgame
[...] — Against the “dual mandate”. [...]