I used to think that the most important objective for monetary policy was to stabilize the price level, and that it mattered less which particular price level was stabilized than that some price level be stabilized. I thought that really bad things happen when there is inflation or deflation, but if the price level — any reasonably broad price level — could be stabilized, whatever fluctuations occurred would be of a second order of magnitude compared to the high inflation or substantial deflation liable to occur without an explicit commitment to price-level stabilization. I also thought, having learned Friedman’s lesson of the natural rate of unemployment a little too well, that aiming for price-level stability would made it unnecessary to worry about preventing unemployment, because high and long-lasting unemployment could not occur without falling prices. That seemed to imply that if you could just ensure that monetary policy would keep prices broadly stable, unemployment would take care of itself. In other words, deliberately trying to reduce unemployment would only get you a temporary reduction in unemployment at the cost of a permanent increase in inflation; a bad bargain, or so, at any rate, it seemed to me.
That was one of the main messages of my book Free Banking and Monetary Reform in which I advocated stabilizing the expected wage level (via a mechanism invented by Earl Thompson). Although I pointed out that stabilizing an output price index could have undesirable effects in case of a supply shock that raised input prices, in retrospect I don’t think that I took that contingency as seriously as I should have. If you try to keep the level of prices constant in the face of such a supply shock, you will succeed only if you can force down nominal wages or the return on investment. Either one is a recipe for a major recession. If you allow output prices to rise to reflect the increased cost of inputs, real wages will fall without a reduction in nominal wages, avoiding the costly adjustment (i.e., reduced output and employment) associated with trying to effect a reduction in nominal wages.
But the problem goes even deeper than that. Suppose you have a central bank that is credibly committed to stabilizing the price level or to stabilizing the rate of inflation at some target level, say, just to pick a number at random, about 2% a year or slightly below that. Then suppose that there is a supply shock, so that the central bank has basically two choices.
The first would be for the central bank to allow the supply shock to work its way through the system, enabling producers to pass through their increased input costs to consumers by providing enough monetary expansion to allow increased input costs to be added to output prices without forcing any other inputs to absorb a nominal reduction in their nominal incomes. Thus to avoid a recession, you would probably need a slightly higher rate of NGDP growth than the rate corresponding to to the one that would have met the inflation target had there been no supply shock. In other words, I am suggesting, though I could be wrong about this, and I invite others to weigh in on this point, that accommodating the supply shock requires a slight loosening of monetary policy relative to what it was before the shock. But if the central bank accommodates the supply shock, it will overshoot its inflation target, undermining its precious inflation-fighting credibility.
The second option of course is to resist the supply shock in order to maintain the precious inflation-fighting credibility of the central bank. But this requires the central bank to tighten its policy, because unless policy is tightened some part of the unexpected increase in input prices will get passed forward into the price of output, forcing the realized rate of inflation to rise above the target rate. The tightening of policy therefore necessarily results in reduced nominal incomes to other inputs (i.e., labor and capital) causing a decline in real output and employment.
At least in broad outline (though I (or we) perhaps have to do some more work on the details), there is nothing really new in this discussion. But I think that there is something else going on here that is not so well understood. The part that is not so well understood is that if the public understands that the central bank cares more about its precious inflation-fighting credibility than about causing a recession, the public will anticipate that the central bank will tighten monetary policy, which means that the public will immediately increase its precautionary demand for money, which means a spontaneous demand-induced tightening of monetary policy even before the central bank lifts a finger.
I have no doubt that something like this was going on in the spring and summer of 2008 when the FOMC kept making periodic and downright scarry statements about how increases in headline inflation caused by rising commodity prices (Oh, Lord, protect us from those rising commodity prices!) were threatening to cause inflation expectations from becoming unanchored even as the economy was rapidly going down the tubes long before the Lehman debacle (and don’t forget that it took the FOMC three whole weeks after Lehman collapsed — during which time there was an already scheduled FOMC meeting at which the status quo was reaffirmed! — to reduce the federal funds rate to 1.5% from the 2% rate at which it had been held since March).
And I also believe that something like this has been going on over the past few weeks as inflation and money-printing hysteria has increased, fueled, among other things, by an unexpected 0.5% increase in the July CPI. I am suggesting that the 0.5% increase in the CPI caused the markets to attach an increased probability to a tightening of monetary policy, causing an increased precautionary demand for money.
In chapter 10 of my book (pp. 218-21) in the section “the lessons of the Monetarist experiment 1979-82,” I described the perverse expectational reactions triggered by the Fed’s attempt to follow the Monetarist prescription for targeting the growth rates of the monetary aggregates. I introduced that section with the following prescient quotation from Hayek’s Denationalization of Money.
As regards Professor Friedman’s proposal of a legal limit on the rate at which a monopolistic issuer of money was to be allowed to increase the quantity in circulation, I can only say that I would not like to see what would happen if under such a provision it ever became known that the amount of cash in circulation was approaching the upper limit and therefore a need for increased liquidity could not be met
The perverse response under inflation targeting when there is a supply shock is, I think, more or less analogous to the one so clearly foreseen by Hayek, which I documented in my book for the 1979-82 period (with intermittent recurrences in 1983-84 as well). Who says history never repeats itself?