Inflation is confusing. The concept makes crazy people crazier. And even worse, it makes otherwise sober people disagree with eachother. Reading through the accounts of QE2 on the internet the past few days have solidified my view that inflation is a thorny enough concept that we should rid it from popular vernacular. Is inflation important? Sure…but what measure of inflation is correct? CPI-U? GDP Deflator? Your crazy uncle’s index? Does inflation help or hurt savers in the current landscape?
If there is anything that gets turned on it’s head when an AD recession hits, it is the concept of inflation. During normal times (full employment and capacity utilization), inflation is harmful as it drives up interest rates, discourages saving, and encourages misallocation of capital. However, none of those things apply to the current situation in which we find ourselves with a large output gap and high unemployment. Thus, we need higher inflation in order to close the output gap (the difference in money expenditures between where we are currently, and the trend rate from the Great Moderation…currently about -13%), but that turns everything that everyone knows about inflation backward. All of a sudden inflation is good for savers, good for the unemployed, and good for economic growth. Well, stable inflation expectations are key…but it’s hard to steer a ship, and it’s hard to get a non-confusing answer out of pundits and other commentators.
In order to square this circle, I propose we forget about inflation. And not just forget about talking about it, but forget about its use in the setting of monetary policy. Instead, we should target nominal expenditure at a steady growth rate (3% a la Woolsey, or 5% a la Sumner, Beckworth, etc.) with level targeting. What advantages does targeting nominal expenditure have? Well…
- Targeting nominal expenditure (NGDP for short) allows monetary policy to better address recessions which arise from both aggregate supply and aggregate demand shocks. David Beckworth has an excellent discussion of this point.
- NGDP is a better indicator of monetary shocks than inflation indicators like CPI. Because prices are sticky, and because measures of inflation are so problematic, a fall in NGDP won’t immediately show up in inflation numbers. Also, if there is a large price shock in something like oil, this will raise the money price of all goods and services, causing anyone focusing on inflation to miss the underlying weak economy…and thus potentially set monetary policy to be too contractionary (sound familiar?).
- NGDP allows us to broaden our focus to aggregates like MZM, asset prices, yields, excess reserves etc. We’ll relinquish our inane focus on interest rates, which are a very problematic indicator of the stance of monetary policy, and have a much better picture of the health of the economy.
- NGDP sounds better. People have an innate fear of inflation. Inflation destroys savings, after all…and we all know frugal people are virtuous. Well, how about, in the event of a recession, instead of economists clamoring against the crowd that we need inflation, they say that we want aggregate expenditures (and thus nominal income) to be at some level higher than it currently is? Money illusion is a powerful motivator. Who would argue with that?
Targeting nominal expenditure would be a beneficial step from both an economic theory perspective, and a public relations perspective. Lets take the confusing concept of price inflation out of our discourse, so that we can see the world more clearly.
P.S. We are currently 13% below the target path from the Great Moderation, and are where we were at before the crash of Sept/Oct 2008. To make that up by 2011:Q3, the Fed would have to target NGDP at $17.6bn (to continue on a 5% NGDP growth path). However, Bill Woolsey favors a 3% growth path for money expenditures, which means that the Fed would only have to target a 13.8% increase by 2011:Q3 (or $16.4bn), and then continue on with 3% growth, level targeting, from then.
Update: Found the link to Beckworth’s article!
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Friday ~ November 5th, 2010 at 8:07 pm
sardonic_sob
And, when NGDP *also* turns out to illustrate that trying to manage the economy is a fool’s game… excuse me, when it turns out that NGDP also needs constant modification in the face of increased knowledge about the nature of the economy and adjustments that give a better picture of the real state of things regardless of the misleading base calculation, what will we use then? Wealthiness?
Friday ~ November 5th, 2010 at 9:31 pm
Niklas Blanchard
What is going to happen to NGDP? Are we not going to be using it as a measure of aggregate activity in 20 years? Or are you saying that stabilizing a growth path of NGDP is the wrong thing to do?
Saturday ~ November 6th, 2010 at 6:04 pm
sardonic_sob
I am saying that you cannot change how much water is in the well by measuring it in different units, or by evaluating the quantity as a change over time instead of a series of discrete measurements.
I understand that NGDP and inflation numbers measure quite different things, and frankly I think you’re on to something in that if you’re going to target something it may be a better target. My point is that if you believe (as I do) that attempting to manage the economy on an continuous basis is not workable, you will naturally be somewhat skeptical of *any basis for targeting at all.*
The economy is, over the infamous long run, going to go where it is going to go. You can try to do things that make the destination a nicer place in general, like funding pure research and whatnot. But you cannot try to steer it if you don’t like the destination it’s pointed at without some basis for it arriving at the new destination other than, “I said so.”
It’s not that I don’t think economies couldn’t be scientifically controlled. I do. It’s that I don’t think we have anything like either the theoretical basis or the computational ability to attempt it with any assurance whatsoever that we won’t just make things worse.
Friday ~ November 5th, 2010 at 9:37 pm
jazzbumpa
Niklas -
The only thing I disagree with is calling the slow death of the American economy, “The Great Moderation.” This has been the great stagnation.
My take, if you’re interested.
http://jazzbumpa.blogspot.com/2010/10/us-economy-is-dying.html
Bob -
GDP is a broad based resultant of total economic activity. It’s not perfect, but nothing in the real world is. Unless you’re just going to shrug and say, “There’s nothing we can do,” which looks like it might actually be your point, you need to have something to work with. Got a better candidate than GDP?
Cheers!
JzB
Saturday ~ November 6th, 2010 at 6:09 pm
sardonic_sob
Nope. Druther target GDP than inflation if those are my choices.
That is, however, kinda sorta, my point. It’s not that I think that temporary and targeted interventions can’t be very effective and produce a good return, it’s that I don’t believe that any government is capable of limiting itself to temporary and targeted interventions. They want to “drive forward along that line until all our citizens have above-average incomes.” This produces things like the recent stagnation that everybody thought was so great and moderate. As Bill Bonner puts it, “Give me a few trillion to spend and I will show you a good time too. You’re not going to like the hangover the next day, though.”
Saturday ~ November 6th, 2010 at 9:50 pm
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