What Should the Fed Target?

Over the past 30 years a consensus has formed among central bankers around the notion that their job is to keep the rate of inflation at or perhaps just under 2 percent a year.  Exactly how they arrived at this figure is not exactly clear to me; I think the idea is that you want inflation to be so low that people aren’t very conscious of it in their everyday lives, but you don’t actually want to bring it down to zero, because if you did, you might inadvertently fall into a deflationary downward spiral.  So about 2 percent inflation provides a bit of protective cushion against drifting into that deflationary danger zone without raising inflation enough to become imbedded in the public consciousness.

Of course there are many different ways to measure inflation, and it was long ago understood by economists that no single price index could perfectly measure what we mean when we talk about the purchasing power of money.  The most popular inflation measure is the consumer price index, but the CPI tracks only a subset of goods, those entering into the budget of a typical urban working household.  In addition, there are all kinds of issues associated with adjusting for quality changes (generally improvement) in the goods consumed over time and issues associated with taking into account the changing composition of the basket of goods the typical urban household purchases (in part in response to relative price changes among the goods in the basket).

In recent years, the Fed has been placing greater emphasis on what is called “core inflation” than on the standard CPI, also referred to as “headline inflation.”  Core inflation subtracts off from the CPI volatile energy and food prices, which, it is argued, are a) highly volatile, so that a given monthly change may present a misleading impression about inflation over a longer time horizon, and b) subject to various forces capable of producing significant price  movements even with no change in monetary conditions.  This reasoning suggests that by cross checking “headline inflation” with “core inflation,” the monetary authorities can reach a better judgment about the danger that inflation might accelerate than by looking at “headline inflation” in isolation.

Interestingly, the FOMC, in 2008, did just the opposite — with disastrous results.  Even though core inflation was fairly well contained in 2008, the Fed viewed with alarm the increases in headline inflation associated with the run up in oil prices in the first half of 2008.  Fearing that high headline inflation would cause inflation expectations to become unanchored, the FOMC refused to cut the Fed Funds rate below 3 percent from March to October — yes October! — 2008 despite all the evidence that the economy, even before the Lehman debacle, was already in, or about to fall into, a recession.

Once again, voices at the Fed and in the FOMC are being raised to focus attention on headline rather than core inflation.   James Bullard, President of the St. Louis Fed, recently (5/18/2011) gave a speech to the Money Marketeers of New York University, dispassionately titled “Measuring Inflation: The Core Is Rotten.”  The speech does not address directly whether current Fed policy is too tight or too loose, but Bullard, who supported QE2, providing crucial support to Bernanke in September 2010 after Bernanke’s Jackson Hole speech, signalling his intention to press forward with another round of quantitative easing, has since signaled his own opposition to further steps toward monetary ease.  What Bullard does do is review a lengthy list of reasons why the Fed should stay focused on headline rather than core inflation.  I have no reason to think that Bullard is not sincere in preferring that the Fed target headline rather than core inflation, but the subtext of Bullard’s remarks suggests to me that he believes that the current rate of headline inflation is higher than he would like it to be and that monetary policy should be adjusted accordingly.

The US focus on  core inflation tends to damage Fed credibility.  As I noted in the introduction, many other central banks have solidified their position on this question by adopting explicit, numerical inflation targets in terms of headline inflation, thus keeping faith with their citizens that they will work to keep headline inflation low and stable.  The Fed should do the same.

But why should headline inflation be the measure of inflation of most concern to the Fed?  Rather than explain, Bullard simply asserts that stabilizing headline inflation is what gives the Fed credibility.

With trips to the gas station and the grocery store being some of the most frequent shopping experiences for many Americans, it is hardly helpful for Fed credibility to appear to exclude all those prices from consideration in the formation of monetary policy.

Historically, the rationale for stabilizing a price index has been that, by doing so, the monetary authority could damp down the business cycle.  This was the position of the great Swedish economist Knut Wicksell in the late nineteenth and early twentieth centuries.  He believed that swings of inflation and deflation were the cause of the business cycle in output and employment.  Stabilize prices in general and you would stabilize the rest of the economy.  The great American economist Irving Fisher reached the same conclusion, characterizing the business cycle as a dance of the dollar.

It was in this spirit that the Federal Reserve Act imposed a dual mandate on the Fed to achieve stable prices while also promoting maximum employment.  Does that dual mandate have any operational meaning?  I think it does.  It means, for starters, that you should not try to reduce inflation when it is already at a historically low level and when reducing it further threatens to decrease, not increase, employment.  That’s all well and good, but how is one to know whether inflation is at historically low levels?  Hasn’t headline CPI inflation has in fact been increasing over the past six months, rising by 3.3%.

I suggest looking at wages.  According to the Employment Cost Index published by the St. Louis Fed, wages between the first quarter of 2001 and the first quarter of 2008 increased at any annual rate of 2.94%.  In only two of those 29 quarters did wages increase at a less than 2% annual rate.  Since the second quarter of 2008, wages have increased at a rate of 1.51%, and for the last 10 quarters in a row wages have increased at a less than 2% annual rate.  So, despite the recent uptick in headline inflation, there is no sign that wage inflation is increasing.  With wages increasing now half as fast as the trend from 2001 to 2008, with the labor market clearly not tightening and unlikely to do so in the foreseeable future, what possible justification can there be, under the dual mandate, or under any reasonable assessment of the risk that  inflation will speed up, for monetary policy to aim at reducing inflation?  No increase in the trend rate of inflation is possible without a roughly corresponding increase in wages.  If wage inflation is virtually absent, there is negligible risk of an increase in the trend rate of inflation.

Throughout his long career, Ralph Hawtrey recommended stabilizing the wage level as the goal of monetary policy.  Hawtrey did not advocate stabilizing a wage index, he advocated stabilizing the wage for unskilled labor.  I am guessing that wages for skilled labor generally rise somewhat faster than the wages of unskilled labor, so we are very close to meeting Hawtrey’s criterion for wage stability.  But the middle of the deepest downturn in 80 years is not the time to pursue the long-term goal of wage stability.  If prices are now rising somewhat faster than wages, it is probably because of recent supply shocks that raised oil prices.  Until wages start rising faster than the 3 percent rate at which they rose from 2001 to 2008, those supply side factors will not translate into a sustained increase in price inflation.  Hawtrey was right.  We should keep our eye on wages.


20 Responses to “What Should the Fed Target?”

  1. 1 Floccina July 21, 2011 at 9:50 pm

    Why try to stabilize wages rather than spending? It seems to me that spending is more encompassing.


  2. 2 João Marcus Marinho Nunes July 22, 2011 at 12:06 am

    Just in the case of IT and PLT, wouldn´t there be a problem with wage targeting if the economy experiences a productivity (supply) shock? A nominal spending level target doesn´t “suffer” from that problem.


  3. 3 Lars Christensen July 22, 2011 at 4:39 am

    David, if you are going down this path (you did long ago I guess…) why not recommend targeting the wage sum rather than an wage index? If you target growth of the wage sum I could imagine that would get more of a stabilisation effect on the economy – and further I guess there is a risk that just targeting wage could become pro-cyclical. Anyway, I am not really advocating this, but to me a nominal wage sum target of lets 5% (pretty much equal to Scott’s NGDP target) would make more sense. And I guess this would be fully in line with Fed’s odd political mandate…


  4. 4 Benjamin Cole July 22, 2011 at 12:50 pm

    Consider this document from the Hong Kong Monetary Authority:

    Click to access CEI_201001.pdf

    It is a study of mainland China’s monetary policy. It concludes:

    “Our estimated monetary reaction functions for the PBoC’s show that the
    key factors of monetary policy are economic growth and inflation, which are in fact the PBoC’s stated mandate. Of the two main policy objectives, the PBoC appears to react more strongly to deviations of growth from targets.”

    Okay, so the Hong Kong Monetary Authority says that mainland China tilts towards growth with their monetary policy. And let’s look at Japan. We know the Bank of Japan puts inflation-fighting first.

    And what has been the result? How have the two nations fared in the last 20 years?

    Answer: China has boomed, while Japan is shriveling.

    This is the argument we need to bring to the public. This is the insight we need at this time.

    I suggest even four or five percent inflation is good for now, maybe even more. Ray Dalio (nation’s biggest hedge fund manager) suggests that without inflation we rot for 10 years deleveraging. Greece, stuck to the euro, is headed for perma-gloom.

    I ask you: Is your ascetic love for low inflation so intense that you are willing to do without sex (economic growth) for 10 years?

    Or, are you long in bonds?


  5. 5 luisharroyos H Arroyo July 22, 2011 at 2:22 pm

    I think that the FOMC cannot neglect any information on the prices an wages evolution. I say “cannot”, not “should not”.
    The most comprehensive measure is obviously NGDP, but it is produce with a very long lag.
    So, in the interlude, FOMC must be concerned with all information about wages and prices.
    I don´t believe in the rigidity of only one rule, as NGDP or Taylor rule. The Riksbank has performed very well with an only mandate (price stability) interpreted by its Government with an ample laxitude.
    Congratulations for your wonderful blog, I´m learning a lot.


  6. 6 David Glasner July 22, 2011 at 2:23 pm

    Floccina, My aim was not to specify the ideal objective for the Fed. Perhaps that was not made as clear as it should have been. I was merely addressing the question of what the Fed, given its current operating procedures, should be looking at to figure out whether policy is too easy, too tight, or just right. My point was that by looking at the recent trend of wages, it is clear that monetary policy is still too tight and that there is no realistic danger of more than a temporary blip in the rate of inflation. If the Fed is concerned about the relevant index to be looking at now, it should give more weight to wages than to either the headline CPI or core inflation. I was not making an argument, which I don’t feel prepared to do just yet, that stabilizing a wage index would be the best possible policy instrument.

    Marcus, Please excuse my denseness, but I can’t figure out what IT and PLT stand for.

    Lars, By wage sum I gather that you mean the total factor income of wage earners. Yes, it seems to me that it would be close to Scott’s NGDP target. I think that we are all coming up with variations on the same essential target, namely one that doesn’t imply the wrong policy response when there is a negative supply shock. For historical reasons I am partial to stabilizing wages, and I offered a suggestion for Fed practice because it fits in more easily to their current policy framework than does targeting NGDP. But I am not necessarily saying that stabilizing a wage index (or targeting some rising time path for the wage index) is better than stabilizing NGDP (or targeting a rising time path for NGDP). I don’t have a really well thought ought opinion on that very important, but somewhat theoretical, question.

    Benjamin, Was that question directed towards me? If so, you are asking the wrong guy. I happen to think that a 10 percent increase in the price level would be a terrific thing, and I am not at all sure that 20 percent wouldn’t be better. But that doesn’t mean that inflation is always the best policy under any circumstances. As Emerson said, a foolish consistency is the hobgoblin of little minds. There is no reason why we shouldn’t be able to distinguish situations where a rapidly growing economy produces deflation because costs decline with the advance of technology and situations in which rising prices are needed to increase depressed expectations of profits. It just depends. Right now we need higher prices, so inflate away.


  7. 7 João Marcus Marinho Nunes July 22, 2011 at 2:31 pm

    My fault! Inflation Target & Price Level Target.


  8. 8 David Glasner July 22, 2011 at 2:42 pm

    Luis, I don’t necessarily disagree. And I am also uneasy about any single rule for determining policy. That strikes me as the kind of rationalism that Michael Oakeshott, whom I greatly admire, found objectionable. But do you think that the Fed is now paying any attention to wages in deciding whether policy is too tight or too easy? Thank you, Luis, for your kind words about this blog. I saw that you quoted extensively a couple of days ago from my posting on gold. My Spanish is almost, but not quite, good enough to understand some of the nice things that you said about my blog to your readers. I will try to live up to your praise.


  9. 9 David Glasner July 22, 2011 at 2:46 pm

    Marcus, I guess that I don’t understand why a supply shock would be a problem if wages are being targeted. If it’s a positive shock then increased productivity is reflected in lower output prices and if it’s a negative shock, then decreased productivity is reflected in higher prices. That’s more or less what you would get from targeting NGDP, no?


  10. 10 luisharroyos H Arroyo July 22, 2011 at 3:10 pm

    I don´t know, I suppose that Bernanke is in a unstable position in FOMC and Congress. But I imagine is impossible not to see the wages are going at a very low rate, lower than the prices.
    I like Oakeshott also, but there is a lot of time that I don´t read him.
    His essay on Conservatism is a Bible for me.


  11. 11 João Marcus Marinho Nunes July 22, 2011 at 5:43 pm

    David. Quite right. My confusion!


  12. 12 Scott Sumner July 23, 2011 at 11:40 am

    David, I like Hawtrey’s idea of targeting unskilled wages. But that would be hard to implement in the US, as it implicitly assumes that unskilled wages trend toward their equilibrium, as wages are renegotiated. But after the recent 40% hike in the minimum wage, that’s no longer true. The all wage index is still the safer choice, in my view.


  13. 13 Benjamin Cole July 23, 2011 at 3:31 pm


    No, it was a question asked of people braying about gold and the need for tight money.

    However, I hope all the NGDP crowd begins to frame the question in this way. Do you want another 10 years of economic rot, just to keep ultra-low inflation rates?

    And the Japan story.

    I am not a formal economist. But I am danged good at framing politico-economic arguments. The NGDP crowd needs to win the public argument.


  14. 14 David Glasner July 23, 2011 at 11:23 pm

    Luis, Yes it is certainly true that Bernanke does not have a free hand. However, he has not given much indication that the policy he is now pursuing is very different from the one he would choose if he did have a free hand. I was specifically referring to Oakeshott’s essay “Rationalism in Politics.”

    Scott, I agree with you about the problem of targeting wages for unskilled labor when the minimum wage is raised.

    Benjamin, Thanks for the clarification. Well, not many economists are very good at packaging their ideas to achieve political influence. Keynes and Friedman were about the best there were at that. There is much to admire about both of them, but I think that their scholarship suffered because of their desire for political influence.


  15. 15 gabe July 25, 2011 at 4:01 pm

    The individuals at the Fed respond to incentives right? They are mortals, not angels agreed? So what happened to the key members of the Fed the last time they created a crisis by leaving rates steady from May-October of 2008 as all the LEI’s crashed?

    The fed as a whole garnered more powers than ever, the fed members handed out billions in benefits to CEO’s of the top financial institutions(who happen to always be in the market for 20k-500k speaches and consulting gigs from ex-Fed members).

    Was ben bernanke fired for famously missing the housing bubble? no…was anyone at the fed fired for this? no

    So it seems to me the individuals at the fed are incentivised to create periodic crisis.


  16. 16 gabe July 25, 2011 at 6:40 pm

    so if the Fed is incentivised to create a crisis then the NGDP targeting crowd or unskilled wage targeting crowd needs to be really loud. Hell Bernanke is a leading missionary of the core-cpi targeting religion! So it shouldn’t be that hard to come to a compromise if he was really working on what he thought was best.

    The pro-gold standard people and the Austrians want to get rid of the federal reserve all together and these people really don’t have any power…nobody listens to them when they say we should shrink government/taxes/end wars to legalize drugs. Focing this gorup into the “non-easing” vote and then blaming them for our problems is absurd.

    Bernanke is not easing because of political games and the incentives he has for creating a crisis….blaming the austrians for bad fed monetary policy is like blaming monks for disco music!


  1. 1 Wages and Inflation « Anthony Collebrusco Trackback on July 22, 2011 at 4:48 pm
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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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