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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!
There has been a lot of chatter around the blogosphere about Narayana Kocherlakota’s speech in Michigan last week, and seeing as I am trying to catch up on news, I think that is a good a place as any to start. First, here is the whole speech, so that you can read it if you would like.
The big focus, especially among left-leaning commentators, has of course been Kocherlakota’s comments on the unemployment situation. The only troubling thing to me about a monetary policymaking body discussing unemployment is the fact that it is happening at all. I don’t believe that there is anything “special” that monetary policy can do to alleviate unemployment — even in a booming economy. The capacity of monetary policy to act is to keep nominal GDP growing at a constant rate, year over year, and to tighten a little when it overshoots and loosen a little when it undershoots — such that the trend path of NGDP is a constant upward slope. I’m not an expert on the welfare-maximizing trend rate of NGDP…but people who are much smarter than me on average advocate 5% NGDP growth.
In any case, in the speech, Kocherlakota breaks down how Fed meetings operate, and then breaks down his “forecast speech” that he gave to the FOMC. Along those lines, he has three points: GDP (real), inflation, and unemployment. On those three points, he has this to say:
Typically, real GDP per person grows between 1.5 and 2 percent per year. If the economy had actually grown at that rate over the past two and a half years, we would have between 7 and 8.2 percent more output per person than we do right now. My forecast is such that we will not make up that 7-8.2 percent lost output anytime soon.
[...]
The Fed’s price stability mandate is generally interpreted as maintaining an inflation rate of 2 percent, and 1 percent inflation is often considered to be too low relative to this stricture. I expect it to remain at about this level during the rest of this year. However, our Minneapolis forecasting model predicts that it will rise back into the more desirable 1.5-2 percent range in 2011.[1]
[...]
Monetary stimulus has provided conditions so that manufacturing plants want to hire new workers. But the Fed does not have a means to transform construction workers into manufacturing workers. [...] Given the structural problems in the labor market, I do not expect unemployment to decline rapidly. My own prediction is that unemployment will remain above 8 percent into 2012.
[1]5yr TIPS spread is at 1.43, 10yr @ 1.55.
Now, not making up the lost employment is partially a function of his previous point about per capita GDP remaining under trend for an extended period of time. This is the cyclical component of unemployment. Cyclical unemployment is created due to the relationship of the economy to the cycle of time. As such, the level of cyclical unemployment correlates well with the business cycle, seasonal factors, etc. I believe that most of the unemployment we are currently experiencing is of cyclical nature.
I think the error in Kocherlakota’s thinking stems from this quote:
Monetary stimulus has provided conditions so that manufacturing plants want to hire new workers. But the Fed does not have a means to transform construction workers into manufacturing workers.
This is wildly baffling. Not only does Kocherlakota make the forecast above — i.e. we will not be hitting any of our targets (nominal or otherwise) any time soon — he also states that he believes that money has been easy. That implies that monetary policy has zero effect on the economy, any time. He also identifies that low rates for an extended period of time are a sign of monetary failure, but does so in a future-orientation. While it is true that low rates can (and do) accompany* a deflationary “trap”, the policy prescription that follows is not to raise short-term rates regardless of the composition of employment. The proper policy response in that situation is to set a positive nominal target, level targeting and commit to move heaven and earth to hit that target.
That, rather than his statements about unemployment, is what I view as Kocherlakota’s underlying problem.
*H/T to Andy Harless in the comments. Also, read his post about Kocherlakota’s statements.
