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Matt Rognlie made this comment on my John Cochrane post:

Woodford is more skeptical of the power of an NGDP target than you are; in particular, although he thinks it would help, he doesn’t think a level target completely eliminates the problem of the zero lower bound. I agree with him, and I suspect that we have similar reasons for this belief. In Woodford’s model, one can prove that the zero lower bound will still pose a barrier in some situations even when there is an NGDP level target, and the central bank will not immediately be able to move the economy to its target. There are various reasons why his model might not be a complete description of reality, but I think it is a pretty good benchmark, and the burden is on you NGDP zen masters to come up with a modification of the model (or alternative model) where the zero lower bound is no longer a barrier. : )

First of all I don’t think that Woodford and I actually disagree all that much. I’m pretty sure we both agree that there is some level of asset purchases (short of buying up planet Earth) that allow you to hit a 5% expected NGDP growth target. Here’s where I think we differ:

1. He thinks the probability that this might require “unconventional purchases” (i.e. non-Treasury debt) is higher than I believe it is. At least for the US circa 2012.

2. He regards Fed purchases of agency debt and German government debt and AAA IBM corporate bonds at fair market prices as non-monetary policy, and I regard it as monetary policy.

3. I regard the Fed purchase and later sale of interest-earning assets at fair market prices with non-interest earning cash and reserves as being far superior to a policy of bridges to nowhere and high-speed rail from Tampa to Orlando. I don’t know how Woodford views that comparison. I’d also expect that sort of Fed policy to be highly profitable, on average.

Over the years I’ve batted down the “credibility” arguments so often that I’m starting to feel like Sisyphus. So here we go again.

Elite macroeconomists have lots of wonderful models. Unfortunately these models are partially built on stylized facts that are actually myths. I’ll focus on three areas: The myth that past attempts at monetary policy have been hamstrung by credibility problems. The myth that an optimal policy at the zero bound requires the Fed to promise to be irresponsible in the future. And the myth that adopting a NGDP target would lack credibility because it would mean abandoning a previous inflation target.

Many macroeconomists have the following ideas in the back of their minds:

1. Volcker was appointed to the Fed in 1979, but inflation didn’t start falling until mid-1981. That’s shows his policy initially lacked credibility. I demolished that myth in this post. For those with limited time, consider:

a. The highest inflation in my lifetime occurred in 1980, when CPI inflation peaked at 13%

b. A sharp but brief recession in early 1980 hurt Carter’s re-election chances.

c. Carter appointed Volcker.

d. Volcker cut the fed funds rate by 800 basis points in the spring of 1980.

e. In response to the sharp rate cuts, NGDP soared at a 19% annual rate in 1980:4 and 1981:1.

f. Volcker tightened sharply in mid 1981, and monthly inflation rates almost immediately plummeted sharply.

2. Then there’s the famous case of the valiant BOJ, fighting for inflation but failing to convince a skeptical Japanese public. I’ve swatted that argument down many times. On one occasion Krugman rebutted my claim with an argument so weak that even the normally ultra-polite Ryan Avent seemed slightly bemused:

And…I’m genuinely mystified. The only thing I can think of that would square this circle is if Mr Krugman and I are using different definitions of the word “prefer”. As best I can tell, he has conclusively shown that Mr Sumner is right, and Japan hasn’t been in a deflationary trap. It just needs to fire all of its central bankers.

Then there are these “time-inconsistency” models that were developed to explain why central banks couldn’t control inflation. Immediately after the ink dried the models became obsolete, as central banks around the world did control inflation. But economists love models, so now they turned them around and tried to show why the Japanese were (supposedly) unable to create inflation. They claimed that you could only exit the liquidity trap by “promising to be irresponsible” in the future, i.e. by promising to run above target inflation after exiting the liquidity trap.

That “irresponsible” assumption is based on the myth that the inflation rate is a good indicator of the welfare costs of inflation. But it isn’t, for all sorts of reasons that I have discussed elsewhere (and George Selgin discussed before me.) What matters is NGDP. The main cost of inflation is that the real tax on capital rises as inflation rises. But in practice the rate of NGDP growth is more important, as high RGDP growth also pushes up nominal interest rates, i.e. nominal returns on capital. Furthermore, when NGDP is below trend (like right now, or in the 1930s) nominal interest rates will be low, even if the growth rate of NGDP was fairly high. So I could much more plausibly write down a model where stable NGDP growth, level targeting, was the policy that minimized the welfare costs of “inflation.” In that model one doesn’t need to “promise to be irresponsible” to exit a liquidity trap, you just need to set policy in a Svenssonian fashion, so that future expected NGDP rises smoothly along a 5% trend line.

With NGDP level targeting there is no need to adopt policies that are temporarily suboptimal, in order to get the desired AD growth. A policy of stable expected NGDP growth, level targeting, is optimal on both employment grounds, and “welfare cost of inflation” grounds, at least compared to any other policy with the save average NGDP growth rate.

Karl Smith recently did a post criticizing John Cochrane’s claim that adoption of NGDP targeting would be non-credible, as it would force the Fed to discard it’s previous policy (presumably inflation targeting.) But there’s another weakness with Cochrane’s argument; the Fed was never really a pure inflation targeter. Rather they have a dual mandate, to keep inflation relatively low and stable, and to keep unemployment close to the natural rate. For several decades the Fed kept NGDP growing at about 5% per year. This policy seemed pretty successful, as the business cycle became less volatile, and inflation stayed relatively low and stable. But not completely stable, as that would imply a single mandate. The Fed always maintained that they allowed some fluctuation in inflation (as during oil price shocks), in order to smooth output. Greenspan hinted on occasion that they were actually targeting NGDP.

Then everything changed in 2008, and the Fed missed badly on both its inflation and employment mandate. In 2009 unemployment soared to 10%, and prices fell (deflation.) Since July 2008, inflation has only averaged 1.1%.

NGDP targeting would bring the Fed back to the pre-2008 policy, which was so successful. Indeed one famous NGDP proponent (Christy Romer) called for a 4.5% target, an obvious nod at the recent estimates of slightly lower trend RGDP growth. Although I don’t think the NGDP target needs to be adjusted for changes in trend RGDP growth, I’d have no objection to a once a decade nudge to reflect changing estimates of trend RGDP. That’s a side issue. The key point is that Romer’s proposal is fully consistent with the Fed’s mandate, and with actual Fed policy pre-2008. There should be no loss of credibility in returning to that successful policy.

On theoretical, practical, and historical grounds, policy credibility is simply not a problem for fiat money central banks.

PS. I couldn’t find the link to the Ryan Avent post.

PPS. Matt Yglesias presents a different argument for why credibility is a phony issue.

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This entry was posted on September 06th, 2012 and is filed under Monetary Policy, Monetary Theory. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



