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Wherein I Try to Calm Professor Blanchard’s Nerves

Olivier Blanchard is rightly counted among the most eminent macroeconomists of our time, and his pronouncements on macroeconomic matters should not be dismissed casually. So his commentary yesterday for the Peterson Institute of International Economics, responding to a previous policy brief, by David Reifschneider and David Wilcox, arguing that the recent burst of inflation is likely to recede, bears close attention.

Blanchard does not reject the analysis of Reifschneider and Wilcox outright, but he argues that they overlook factors that could cause inflation to remain high unless policy makers take more aggressive action to bring inflation down than is recommended by Reifschneider and Wilcox. Rather than go through the details of Blanchard’s argument, I address the two primary concerns he identifies: (1) the potential for inflation expectations to become unanchored, as they were in the 1970s and early 1980s, by persistent high inflation, and (2) the potential inflationary implications of wage catchup after the erosion of real wages by the recent burst of inflation.

Unanchored Inflation Expectations and the Added Cost of a Delayed Response to Inflation

Blanchard cites a forthcoming book by Alan Blinder on soft and hard landings from inflation in which Blinder examines nine Fed tightening episodes in which tightening was the primary cause of a slowdown or a recession. Based on the historical record, Blinder is optimistic that the Fed can manage a soft landing if it needs to reduce inflation. Blanchard doesn’t share Blinder’s confidence.

[I]n most of the episodes Blinder has identified, the movements in inflation to which the Fed reacted were too small to be of direct relevance to the current situation, and the only comparable episode to today, if any, is the episode that ended with the Volcker disinflation of the early 1980s.
I find that a scary comparison. . . .
[I]t shows what happened when the Fed got seriously “behind the curve” in 1974–75. . . . It then took 8 years, from 1975 to 1983, to reduce inflation to 4 percent.

And I find Blanchard’s comparison of the 1975-1983 period with the current situation problematic. First, he ignores the fact that the 1975-1983 episode did not display a steady rate of inflation or a uniform increase in inflation from 1975 until Volcker finally tamed it by way of the brutal 1981-82 recession. As I’ve explained previously in posts on the 1970s and 1980s (here, here, and here), and in chapters 7 and 8 of my book Studies in the History of Monetary Theory the 1970s inflation was the product of a series of inflationary demand-side and supply-shocks and misguided policy responses by the Fed, guided by politically motivated misconceptions, with little comprehension of the consequences of its actions.

It would be unwise to assume that the Fed will never embark on a similar march of folly, but it would be at least as unwise to adopt a proposed policy on the assumption that the alternative to that policy would be a repetition of the earlier march. What commentary on the 1970s largely overlooks is that there was an enormous expansion of the US labor force in that period as baby boomers came of age and as women began seeking and finding employment in steadily increasing numbers. The labor-force participation rate in the 1950s and 1960s fluctuated between about 58% to about 60%, mirroring fluctuations in the unemployment rate. Between 1970 and 1980 the labor force participation rate rose from just over 60% to just over 64% even as the unemployment rate rose from about 5% to over 7%. The 1970s were not, for the most part, a period of stagflation, but a period of inflation and strong growth interrupted by one deep recession (1974-75) and bookended by two minor recessions (1969-70) and (1979-80). But the rising trend of unemployment during the decade was largely attributable not to stagnation but to a rapidly expanding labor force and a rising labor participation rate.

The rapid increase in inflation in 1973 was largely a policy-driven error of the Nixon/Burns collaboration to ensure Nixon’s reelection in 1972 without bothering to taper the stimulus in 1973 after full employment was restored just in time for Nixon’s 1972 re-election. The oil shock of 1973-74 would have justified allowing a transitory period of increased inflation to cushion the negative effect of the increase in energy prices and to dilute the real magnitude of the nominal increase in oil prices. But the combined effect of excess aggregate demand and a negative supply shock led to an exaggerated compensatory tightening of monetary policy that led to the unnecessarily deep and prolonged recession in 1974-75.

A strong recovery ensued after the recession which, not surprisingly, was associated with declining inflation that fell below 5% in 1976. However, owing to the historically high rate of unemployment, only partially attributable to the previous recession, the incoming Carter administration promoted expansionary fiscal and monetary policies, which Arthur Burns, hoping to be reappointed by Carter to another term as Fed Chairman, willingly implemented. Rather than continue on the downward inflationary trend inherited from the previous administration, inflation resumed its upward trend in 1977.

Burns’s hopes to be reappointed by Carter were disappointed, but his replacement G. William Miller made no effort to tighten monetary policy to reverse the upward trend in inflation. A second oil shock in 1979 associated with the Iranian Revolution and the taking of US hostages in Iran caused crude oil prices over the course in 1979 to more than double. Again, the appropriate monetary-policy response was not to tighten monetary policy but to accommodate the price increase without causing a recession.

However, by the time of the second oil shock in 1979, inflation was already in the high single digits. The second oil shock, combined with the disastrous effects of the controls on petroleum prices carried over from the Nixon administration, created a crisis atmosphere that allowed the Reagan administration, with the cooperation of Paul Volcker, to implement a radical Monetarist anti-inflation policy. The policy was based on the misguided presumption that keeping the rate of growth of some measure of the money stock below a 5% annual rate would cure inflation with little effect on the overall economy if it were credibly implemented.

Volcker’s reputation was such that it was thought by supporters of the policy that his commitment would be relied upon by the public, so that a smooth transition to a lower rate of inflation would follow, and any downturn would be mild and short-lived. But the result was an unexpectedly deep and long-lasting recession.

The recession was needlessly prolonged by the grave misunderstanding of the causal relationship between the monetary aggregates and macroeconomic performance that had been perpetrated by Milton Friedman’s anti-Keynesian Monetarist counterrevolution. After triggering the sharpest downturn of the postwar era, the Monetarist anti-inflation strategy adopted by Volcker was, in the summer of 1982, on the verge of causing a financial crisis before Volcker announced that the Fed would no longer try to target any of the monetary aggregates, an announcement that triggered an immediate stock-market boom and, within a few months, the start of an economic recovery.

Thus, Blanchard is wrong to compare our current situation to the entire 1975-1983 period. The current situation, rather, is similar to the situation in 1973, when an economy, in the late stages of a recovery with rising inflation, was subjected to a severe supply shock. The appropriate response to that supply shock was not to tighten monetary policy, but merely to draw down the monetary stimulus of the previous two years. However, the Fed, perhaps shamed by the excessive, and politically motivated, monetary expansion of the previous two years, overcompensated by tightening monetary policy to counter the combined inflationary impact of its own previous policy and the recent oil price increase, immediately triggering the sharpest downturn of the postwar era. That is the lesson to draw from the 1970s, and it’s a mistake that the Fed ought not repeat now.

The Catch-Up Problem: Are Rapidly Rising Wages a Ticking Time-Bomb

Blanchard is worried that, because price increases exceeded wage increases in 2021, causing real wages to fall in 2021, workers will rationally assume, and demand, that their nominal wages will rise in 2022 to compensate for the decline in real wages, thereby fueling a further increase in inflation. This is a familiar argument based on the famous short-run Phillips-Curve trade-off between inflation and unemployment. Reduced unemployment resulting from the real-wage reduction associated with inflation will cause inflation to increase.

This argument is problematic on at least two levels. First, it presumes that the Phillips Curve represents a structural relationship, when it is merely a reduced form, just as an observed relationship between the price of a commodity and sales of that commodity is a reduced form, not a demand curve. Inferences cannot be made from a reduced form about the effect of a price change, nor can inferences about the effect of inflation be made from the Phillips Curve.

But one needn’t resort to a somewhat sophisticated argument to see why Blanchard’s fears that wage catchup will lead to a further round of inflation are not well-grounded. Blanchard argues that business firms, having pocketed windfall profits from rising prices that have outpaced wage increases, will grant workers compensatory wage increases to restore workers’ real wages, while also increasing prices to compensate themselves for the increased wages that they have agreed to pay their workers.

I’m sorry, but with all due respect to Professor Blanchard, that argument makes no sense. Evidently, firms have generally enjoyed a windfall when market conditions allowed them to raise prices without raising wages. Why, if wages finally catch up to prices, will they raise prices again? Either firms can choose, at will, how much profit to make when they set prices or their prices are constrained by market forces. If Professor Blanchard believes that firms can simply choose how much profit they make when they set prices, then he seems to be subscribing to Senator Warren’s theory of inflation: that inflation is caused by corporate greed. If he believes that, in setting prices, firms are constrained by market forces, then the mere fact that market conditions allowed them to increase prices faster than wages rose in 2021 does not mean that, if market conditions cause wages to rise at a faster rate than they did in 2022, firms, after absorbing those wage increases, will automatically be able to maintain their elevated profit margins in 2022 by raising prices in 2022 correspondingly.

The market conditions facing firms in 2022 will be determined by, among other things, the monetary policy of the Fed. Whether firms are able to raise prices in 2022 as fast as wages rise in 2022 will depend on the monetary policy adopted by the Fed. If the Fed’s monetary policy aims at gradually slowing down the rate of increase in nominal GDP in 2022 from the 2021 rate of increase, firms overall will not easily be able to raise prices as fast as wages rise in 2022. But why should anyone expect that firms that enjoyed windfall profits from inflation in 2021 will be able to continue enjoying those elevated profits in perpetuity?

Professor Blanchard posits simple sectoral equations for the determination of the rate of wage increases and for the rate of price increases given the rate of wage increases. This sort of one-way causality is much too simplified and ignores the fundamental fact all prices and wages and expectations of future prices and wages are mutually determined in a simultaneous system. One can’t reason from a change in a single variable and extrapolate from that change how the rest of the system will adjust.

How Martin Feldstein Learned to Stop Worrying and Love Inflation

Published July 5, 2016 Martin Feldstein , nominal GDP targeting 8 Comments
Tags: price-level targeting

Martin Feldstein and I go back a ways. Not that I have ever met him, which I haven’t, or that he has ever heard of me, which he probably hasn’t, but I have been following his mostly deplorable commentary on Fed policy since at least 2010 when he published an op-ed piece in the Financial Times, “QE2 is risky and should be limited,” which was sufficiently obtuse to provoke me to write a letter to the editor in response. A year and a half later, after I had started this blog – five years ago to the day on July 5, 2011 – Feldstein wrote an op-ed (“The Federal Reserve’s Policy Dead End”) in the Wall Street Journal, to which he is a regular contributor, in which he offered another misguided critique of quantitative easing, eliciting a blog post from me in response.

Well, now, almost six years after our first encounter, Feldstein has written another op-ed (“Where the Fed Will Be When the Next Downturn Comes“) for the Wall Street Journal which actually shows some glimmers of enlightenment on Feldstein’s part. Always eager to offer encouragement to slow learners, I am glad to be able to report that Feldstein seems to making some headway in understanding how monetary policy operates. He is still far from having mastered the material, but he does seem to be on the right track. If he keeps progressing, the Wall Street Journal will probably stop publishing his op-eds, which would be powerful evidence that he had progressed in understanding of the basics of monetary policy.

The Fed’s traditional response to an economic slump is to cut rates sharply in order to stimulate interest-sensitive spending. When the U.S. economy headed into recession at the end of 2007, the Fed cut the short-term federal-funds rate by three percentage points within 12 months. But it can’t do that anytime soon with short rates at less than 1%. And raising the federal-funds rate now to 3% or more would push the economy into recession.

Yet, whether by accident or intent, Fed policy is headed down a path that could eventually solve this problem. The Fed’s plan to continue a very easy monetary policy over the next few years is likely to drive the inflation rate to more than 3%. The Fed could then raise the federal-funds rate rapidly, reaching at least a 3% nominal rate, while still keeping a low or negative real fed-funds rate. This would put the Fed in a position to cut rates sharply when a new downturn occurred.

Bravo, Professor Feldstein! If only he had seen the light back in 2010 when he wrote the following in the Financial Times:

Under the label of QE, the Fed will buy long-term government bonds, perhaps one trillion dollars or more, adding an equal amount of cash to the economy and to banks’ excess reserves. Expectation of this has lowered long-term interest rates, depressed the dollar’s international value, bid up the price of commodities and farm land and raised share prices. . . .

Ahead, when the US economy does begin to grow, the increased cash on banks’ balance sheets will make the Fed’s exit strategy harder. It was previously “cautiously optimistic” it would be able to contain the inflationary pressures that could be unleashed by banks with a trillion dollars of excess reserves. This will be harder if the amount of excess reserves is doubled. This could lead to much higher interest rates to restrain demand or to an unwanted rise in inflation.

But now Feldstein is singing a different tune:

Based on the Fed’s own numbers, the real federal-funds rate will still be negative at the end of 2017. All of this is aimed at driving down the unemployment rate to only 4.6% in 2018, the median of the Federal Open Market Committee’s projections. Since that rate is less than the 4.8% rate Fed policy makers judge to be the long-term sustainable rate, their projections of unemployment imply that inflation will continue to rise beyond the Fed’s stated 2% target.

If the Fed succeeds in achieving this—raising the inflation rate above 3% and then raising the fed-funds rate close to that level without pushing the economy into recession—it will have solved the problem of having a high-enough fed-funds rate to deal with a traditional economic downturn.

Financial markets may of course get nervous if the Fed continues to have a very low interest rate even after it has achieved its dual goals of low unemployment and a 2% inflation rate. But the Fed could then argue that the 2% inflation rate was never intended as a ceiling but as an average rate to be achieved over time. Since annual inflation has been below 2% for more than three years, it would arguably be consistent with the Fed’s goal to have inflation temporarily above 2%.

So Professor Feldstein seems at last to have figured out that whether inflation is bad or “unwanted” depends not just on an arbitrary number, but on the overall economic environment. If real interest rates are very low or negative, as they are now, the optimal inflation target must be higher than when the real interest rate is above 3%.

But old habits are hard to break, and Feldstein is still nervous about 3% inflation, even in an environment like ours in which real interest rates are low and falling, as they have been doing for some time, even though measured inflation has turned up ever so slightly, largely reflecting a minor rebound in oil prices, since the first quarter of 2016.

Of course, this path of future inflation and interest rates may not be what the Fed has in mind. But it does look consistent with the Fed’s current actions and its projected plans for interest rates over the next two years. It would be a clever policy but it would also be a policy of high-risk fine-tuning.

It’s risky because the financial markets may not be convinced that the Fed will act to reverse an inflation rate that has drifted above 3% and continues to rise. That could cause long-term interest rates to rise sharply, leading to declines in the prices of equities and of commercial real estate. The resulting higher mortgage rates would depress house prices and housing demand. The higher long-term interest rates would also inflict large losses on bondholders who had bought long-term bonds with very low coupons. These financial losses could precipitate an economic downturn. Fed actions to cut its newly increased fed-funds rate might not be enough to reverse that downturn.

If Feldstein is worried that a temporary increase in the rate of inflation might unleash uncontrollable inflationary expectations, he ought to read up on price-level targeting (PLT) or on nominal gross domestic product level targeting (NGDPLT). When the policy target is the path of the price level or of NGDP, inflation expectations are sensitive not to the current rate of inflation but to where the price level is relative to its target path or where NGDP is relative to its target path. So when, under level targeting, inflation speeds up temporarily after having previously undershot its target path, there is no reason for the corrective temporary rise in inflation to cause inflation expectations to explode, as Feldstein fears they would. Feldstein should read up on level targeting before he writes his next op-ed. Although the Wall Street Journal might not be too happy with it, I am sure that, as a distinguished Harvard Professor, he will have no troubled getting it published somewhere else, maybe even in the Financial Times.

Repeat after Me: Inflation’s the Cure not the Disease

Published June 4, 2015 Andrew Jalil , Brad Delong , Gisela Rua , Great Depression , Hawtrey , Jack Hirshleifer , liquidity trap , Martin Feldstein , nominal GDP targeting , Paul Krugman , Tony Yates 29 Comments

Last week Martin Feldstein triggered a fascinating four-way exchange with a post explaining yet again why we still need to be worried about inflation. Tony Yates responded first with an explanation of why money printing doesn’t work at the zero lower bound (aka liquidity trap), leading Paul Krugman to comment wearily about the obtuseness of all those right-wingers who just can’t stop obsessing about the non-existent inflation threat when, all along, it was crystal clear that in a liquidity trap, printing money is useless.

I’m still not sure why relatively moderate conservatives like Feldstein didn’t find all this convincing back in 2009. I get, I think, why politics might predispose them to see inflation risks everywhere, but this was as crystal-clear a proposition as I’ve ever seen. Still, even if you managed to convince yourself that the liquidity-trap analysis was wrong six years ago, by now you should surely have realized that Bernanke, Woodford, Eggertsson, and, yes, me got it right.

But no — it’s a complete puzzle. Maybe it’s because those tricksy Fed officials started paying all of 25 basis points on reserves (Japan never paid such interest). Anyway, inflation is just around the corner, the same way it has been all these years.

Which surprisingly (not least to Krugman) led Brad DeLong to rise to Feldstein’s defense (well, sort of), pointing out that there is a respectable argument to be made for why even if money printing is not immediately effective at the zero lower bound, it could still be effective down the road, so that the mere fact that inflation has been consistently below 2% since the crash (except for a short blip when oil prices spiked in 2011-12) doesn’t mean that inflation might not pick up quickly once inflation expectations pick up a bit, triggering an accelerating and self-sustaining inflation as all those hitherto idle balances start gushing into circulation.

That argument drew a slightly dyspeptic response from Krugman who again pointed out, as had Tony Yates, that at the zero lower bound, the demand for cash is virtually unlimited so that there is no tendency for monetary expansion to raise prices, as if DeLong did not already know that. For some reason, Krugman seems unwilling to accept the implication of the argument in his own 1998 paper that he cites frequently: that for an increase in the money stock to raise the price level – note that there is an implicit assumption that the real demand for money does not change – the increase must be expected to be permanent. (I also note that the argument had been made almost 20 years earlier by Jack Hirshleifer, in his Fisherian text on capital theory, Capital Interest and Investment.) Thus, on Krugman’s own analysis, the effect of an increase in the money stock is expectations-dependent. A change in monetary policy will be inflationary if it is expected to be inflationary, and it will not be inflationary if it is not expected to be inflationary. And Krugman even quotes himself on the point, referring to

my call for the Bank of Japan to “credibly promise to be irresponsible” — to make the expansion of the base permanent, by committing to a relatively high inflation target. That was the main point of my 1998 paper!

So the question whether the monetary expansion since 2008 will ever turn out to be inflationary depends not on an abstract argument about the shape of the LM curve, but about the evolution of inflation expectations over time. I’m not sure that I’m persuaded by DeLong’s backward induction argument – an argument that I like enough to have used myself on occasion while conceding that the logic may not hold in the real word – but there is no logical inconsistency between the backward-induction argument and Krugman’s credibility argument; they simply reflect different conjectures about the evolution of inflation expectations in a world in which there is uncertainty about what the future monetary policy of the central bank is going to be (in other words, a world like the one we inhabit).

Which brings me to the real point of this post: the problem with monetary policy since 2008 has been that the Fed has credibly adopted a 2% inflation target, a target that, it is generally understood, the Fed prefers to undershoot rather than overshoot. Thus, in operational terms, the actual goal is really less than 2%. As long as the inflation target credibly remains less than 2%, the argument about inflation risk is about the risk that the Fed will credibly revise its target upwards.

With the both Wickselian natural real and natural nominal short-term rates of interest probably below zero, it would have made sense to raise the inflation target to get the natural nominal short-term rate above zero. There were other reasons to raise the inflation target as well, e.g., providing debt relief to debtors, thereby benefitting not only debtors but also those creditors whose debtors simply defaulted.

Krugman takes it for granted that monetary policy is impotent at the zero lower bound, but that impotence is not inherent; it is self-imposed by the credibility of the Fed’s own inflation target. To be sure, changing the inflation target is not a decision that we would want the Fed to take lightly, because it opens up some very tricky time-inconsistency problems. However, in a crisis, you may have to take a chance and hope that credibility can be restored by future responsible behavior once things get back to normal.

In this vein, I am reminded of the 1930 exchange between Hawtrey and Hugh Pattison Macmillan, chairman of the Committee on Finance and Industry, when Hawtrey, testifying before the Committee, suggested that the Bank of England reduce Bank Rate even at the risk of endangering the convertibility of sterling into gold (England eventually left the gold standard a little over a year later)

MACMILLAN. . . . the course you suggest would not have been consistent with what one may call orthodox Central Banking, would it?

HAWTREY. I do not know what orthodox Central Banking is.

MACMILLAN. . . . when gold ebbs away you must restrict credit as a general principle?

HAWTREY. . . . that kind of orthodoxy is like conventions at bridge; you have to break them when the circumstances call for it. I think that a gold reserve exists to be used. . . . Perhaps once in a century the time comes when you can use your gold reserve for the governing purpose, provided you have the courage to use practically all of it.

Of course the best evidence for the effectiveness of monetary policy at the zero lower bound was provided three years later, in April 1933, when FDR suspended the gold standard in the US, causing the dollar to depreciate against gold, triggering an immediate rise in US prices (wholesale prices rising 14% from April through July) and the fastest real recovery in US history (industrial output rising by over 50% over the same period). A recent paper by Andrew Jalil and Gisela Rua documents this amazing recovery from the depths of the Great Depression and the crucial role that changing inflation expectations played in stimulating the recovery. They also make a further important point: that by announcing a price level target, FDR both accelerated the recovery and prevented expectations of inflation from increasing without limit. The 1933 episode suggests that a sharp, but limited, increase in the price-level target would generate a faster and more powerful output response than an incremental increase in the inflation target. Unfortunately, after the 2008 downturn we got neither.

Maybe it’s too much to expect that an unelected central bank would take upon itself to adopt as a policy goal a substantial increase in the price level. Had the Fed announced such a goal after the 2008 crisis, it would have invited a potentially fatal attack, and not just from the usual right-wing suspects, on its institutional independence. Price stability, is after all, part of dual mandate that Fed is legally bound to pursue. And it was FDR, not the Fed, that took the US off the gold standard.

But even so, we at least ought to be clear that if monetary policy is impotent at the zero lower bound, the impotence is not caused by any inherent weakness, but by the institutional and political constraints under which it operates in a constitutional system. And maybe there is no better argument for nominal GDP level targeting than that it offers a practical and civilly reverent way of allowing monetary policy to be effective at the zero lower bound.

Charles Goodhart on Nominal GDP Targeting

Published January 23, 2013 Charles Goodhart , inflation , Mark Carney , monetary policy , nominal GDP targeting , Phillips Curve 18 Comments

Charles Goodhart might just be the best all-around monetary economist in the world, having made impressive contributions to both monetary theory and the history of monetary theory, to monetary history, and the history of monetary institutions, especially of central banking, and to the theory and, in his capacity as chief economist of the Bank of England, practice of monetary policy. So whenever Goodhart offers his views on monetary policy, it is a good idea to pay close attention to what he says. But if there is anything to be learned from the history of economics (and I daresay the history of any scientific discipline), it is that nobody ever gets it right all the time. It’s nice to have a reputation, but sadly reputation provides no protection from error.

In response to the recent buzz about targeting nominal GDP, Goodhart, emeritus professor at the London School of Economics and an adviser to Morgan Stanley along with two Morgan Stanley economists, Jonathan Ashworth and Melanie Baker, just published a critique of a recent speech by Mark Carney, Governor-elect of the Bank of England, in which Carney seemed to endorse targeting the level of nominal GDP (hereinafter NGDPLT). (See also Marcus Nunes’s excellent post about Goodhart et al.) Goodhart et al. have two basic complaints about NGDPLT. The first one is that our choice of an initial target level (i.e., do we think that current NGDP is now at its target or away from its target and if so by how much) and of the prescribed growth in the target level over time would itself create destabilizing uncertainty in the process of changing to an NGDPLT monetary regime. The key distinction between a level target and a growth-rate target is that the former requires a subsequent compensatory adjustment for any deviation from the target while the latter requires no such adjustment for a deviation from the target. Because deviations will occur under any targeting regime, Goodhart et al. worry that the compensatory adjustments required by NGDPLT could trigger destabilizing gyrations in NGDP growth, especially if expectations, as they think likely, became unanchored.

This concern seems easily enough handled if the monetary authority is given say a 1-1.5% band around its actual target within which to operate. Inevitable variations around the target would not automatically require an immediate rapid compensatory adjustment. As long as the monetary authority remained tolerably close to its target, it would not be compelled to make a sharp policy adjustment. A good driver does not always drive down the middle of his side of the road, the driver uses all the space available to avoid having to make an abrupt changes in the direction in which the car is headed. The same principle would govern the decisions of a skillful monetary authority.

Another concern of Goodhart et al. is that the choice of the target growth rate of NGDP depends on how much real growth,we think the economy is capable of. If real growth of 3% a year is possible, then the corresponding NGDP level target depends on how much inflation policy makers believe necessary to achieve that real GDP growth rate. If the “correct” rate of inflation is about 2%, then the targeted level of NGDP should grow at 5% a year. But Goodhart et al. are worried that achievable growth may be declining. If so, NGDPLT at 5% a year will imply more than 2% annual inflation.

Effectively, any overestimation of the sustainable real rate of growth, and such overestimation is all too likely, could force an MPC [monetary policy committee], subject to a level nominal GDP target, to soon have to aim for a significantly higher rate of inflation. Is that really what is now wanted? Bring back the stagflation of the 1970s; all is forgiven?

With all due respect, I find this concern greatly overblown. Even if the expectation of 3% real growth is wildly optimistic, say 2% too high, a 5% NGDP growth path would imply only 4% inflation. That might be too high a rate for Goodhart’s taste, or mine for that matter, but it would be a far cry from the 1970s, when inflation was often in the double-digits. Paul Volcker achieved legendary status in the annals of central banking by bringing the US rate of inflation down to 3.5 to 4%, so one needs to maintain some sense of proportion in these discussions.

Finally, Goodhart et al. invoke the Phillips Curve.

[A]n NGDP target would appear to run counter to the previously accepted tenets of monetary theory. Perhaps the main claim of monetary economics, as persistently argued by Friedman, and the main reason for having an independent Central Bank, is that over the medium and longer term monetary forces influence only monetary variables. Other real (e.g. supply-side) factors determine growth; the long-run Phillips curve is vertical. Do those advocating a nominal GDP target now deny that? Do they really believe that faster inflation now will generate a faster, sustainable, medium- and longer-term growth rate?

While it is certainly undeniable that Friedman showed, as, in truth, many others had before him, that, for an economy in approximate full-employment equilibrium, increased inflation cannot permanently reduce unemployment, it is far from obvious (to indulge in bit of British understatement) that we are now in a state of full-employment equilibrium. If the economy is not now in full-employment equilibrium, the idea that monetary-neutrality propositions about money influencing only monetary, but not real, variables in the medium and longer term are of no relevance to policy. Those advocating a nominal GDP target need not deny that the long-run Phillips Curve is vertical, though, as I have argued previously (here, here, and here) the proposition that the long-run Phillips Curve is vertical is very far from being the natural law that Goodhart and many others seem to regard it as. And if Goodhart et al. believe that we in fact are in a state of full-employment equilibrium, then they ought to say so forthrightly, and they ought to make an argument to justify that far from obvious characterization of the current state of affairs.

Having said all that, I do have some sympathy with the following point made by Goodhart et al.

Given our uncertainty about sustainable growth, an NGDP target also has the obvious disadvantage that future certainty about inflation becomes much less than under an inflation (or price level) target. In order to estimate medium- and longer-term inflation rates, one has first to take some view about the likely sustainable trends in future real output. The latter is very difficult to do at the best of times, and the present is not the best of times. So shifting from an inflation to a nominal GDP growth target is likely to have the effect of raising uncertainty about future inflation and weakening the anchoring effect on expectations of the inflation target.

That is one reason why in my book Free Banking and Monetary Reform, I advocated Earl Thompson’s proposal for a labor standard aimed at stabilizing average wages (or, more precisely, average expected wages). But if you stabilize wages, and productivity is falling, then prices must rise. That’s just a matter of arithmetic. But there is no reason why the macroeconomically optimal rate of inflation should be invariant with respect to the rate of technological progress.

HT: Bill Woolsey

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

Uneasy Money

Archive for the 'nominal GDP targeting' Category

Wherein I Try to Calm Professor Blanchard’s Nerves

How Martin Feldstein Learned to Stop Worrying and Love Inflation

Repeat after Me: Inflation’s the Cure not the Disease

Charles Goodhart on Nominal GDP Targeting

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