Monthly Archives: August 2012

Bagehot on Monetary Policy

“To lend a great deal, and yet not give the public confidence that you will lend sufficiently and effectually, is the worst of all policies; but it is the policy now pursued.”

– Walter Bagehot, Lombard Street

Question of the Day

If it was so obvious that this recovery would be slow, then the Administration’s forecasts should have reflected it. Were they saying at the time, “normally, the economy bounces back quickly after deep recessions, but it’s destined to be slow this time, because recoveries from housing “bubbles” and financial crises are always slow?”

That is John Cochrane. His answer by the way is: “No, as it turns out.” The whole post is worth reading.

Monetary Policy, Level Targeting, and Political Coalitions

In a recent post Nick Rowe writes: “Who else can we get on our side? What sort of coalition could be built to support politically a commitment by central banks to a higher level-path of NGDP?”

The longer the process goes on, the more that I think that the policy battle is lost for level targeters for the time being, but not necessarily the future. The problem that those who want a NGDP level target or even a price level target face is that there is uncertainty about the policy — some warranted and some not — coupled with the fact that there is no precedent for such policy actions. Think of Fed policy under Paul Volcker. Would his policy have been possible without both the monetarist counter-revolution and the experience of the Great Inflation in the 1970s? I think not (although this is more conjecture than hard fact).

The Keynesian consensus prior to the late 1970s was that there was a particular rate of inflation associated with a particular level of unemployment. Higher inflation was a necessary trade-off to ensure lower unemployment. And if unionization or monopolization became stronger the curve would shift up and we would have to tolerate higher inflation in the face of the same level of unemployment. Even Arthur Burns, which I detail in my paper on the Great Moderation but can be understood in more detail by reading his diary, came to the view that incomes policies were necessary to restrain inflation. Think of how remarkably backward this period was. The Fed chairman didn’t think he had any responsibility for inflation! But a large portion of the discipline was with him. The policy regime was only able to change because (1) incomes policies were clearly failing, and (2) the monetarist counter-revolution offered the prescription.

Milton Friedman was arguing that inflation was a monetary phenomenon as far back as 1963 — and perhaps sooner — based careful and thorough research on a century of U.S. history. However, the United States experienced a decade of high rates of inflation before the policy regime was able to not only move away from disastrous policies, but also employ the type of monetary policies (at least publicly) that monetarists had recommended — low, stable rates of money growth.

The problem that those who want level targeting face is that (1) the theoretical underpinnings are not as clear as say the monetarist prescription for inflation, (2) there is very little evidence — good or bad — with respect to level-targeting, and (3) a failure — or perceived failure — of the policy.

With regards to point (1), consider a simple example. There are two idea of a Phillips curve. The first is the New Keynesian view in which

\pi_t = E_t \pi_{t+1} + (1/\alpha) y_t

where \pi_t is inflation E_t \pi_{t+1} is expected inflation and y_t is the output gap.

A monetarist, or expectation-augmented Phillips curve, is

y_t = \alpha (\pi_t - E_t \pi_{t+1})

Couple these ideas with an IS equation. In the NK model, higher short-term expected inflation raises output and inflation. In the monetarist version, an increase in inflation expectations increases output through the IS equation and reduces output through the expectations-augmented Phillips curve. Output could actually fall in the second scenario if \alpha is greater than the interest elasticity in the IS equation. Even if it doesn’t, an increase in short-run expectations of inflation would predominantly cause an increase in inflation rather than output. This brings me to my next point.

With regards to point (2), Scott Sumner and David Beckworth like to point to the devaluation of gold. Even as someone would would support an NGDP level target, I am skeptical that this provides evidence that the current Federal Reserve could necessarily achieve this goal. In this case of the devaluation of gold, the balance of payments will see to it that there is a necessary adjustment in the price level. That is Commodity Money 101. In the present context, there is no automatic mechanism and the Fed is hindered by the fact that they have already doubled the size of their balance sheet. Suppose that the Fed announced that they would buy as many assets as necessary to achieve an NGDP level target. This would mean that the Fed would have to commit to unlimited asset purchases until they reach their goal, which might bring them under political pressure and test their resolve. In addition, if inflation began to rise rapidly (rising from say 2% to 6%), this might also put the Fed under political pressure and test their resolve.

In addition, the Fed has a great deal invested in the credibility that they have achieved from stabilizing inflation around 2% for the past 20 years. Jim Bullard catches a lot of flak by those who favor additional easing. However, of all the Fed presidents who are skeptical of additional easing, he is the most clear on why he opposes such action. Bullard clearly sees the Fed’s main objective as that of inflation targeting — not price level targeting. In all his speeches he has praised quantitative easing for allowing the Fed to maintain a rate of inflation consistent with their 2% goal. He doesn’t oppose easing because he is a dunce (as some of these critics would have you believe), he opposes easing because he thinks that the Fed has achieved its objective. Do not discount this view within the Federal Reserve itself.

Thus, if level targeters want to achieve some level of acceptance and shape monetary policy, they need to provide evidence for its success (and within contemporary monetary regimes) and a more solid theoretical underpinning for why level targeting is preferable. Change takes time. Level targeters are almost certainly not going to be successful in the present. There are few political coalitions that rally around uncertain policy prescriptions. However, if they can take the steps I just described, they might be able to have an effect on policy in the future.