Facebook Twitter LinkedIn

I plan to talk about the new paper by Gavyn Davies, Martin Brookes, Ziad Daoud and Juan Antolin-Diaz, but first a brief digression.

Suppose you were a long-time advocate of a stable monetary base, and called for the policy to be enacted in 1929. Most likely policymakers would have rejected your advice—why change policy when the economy’s doing fine? Then in October 1930 they notice that the US base has fallen 7% over 12 months, plunging us into a deep slump. Now they enact the policy and it’s a complete disaster. The actual monetary base rose sharply after October 1930, and yet the economy plunged ever deeper into depression. A stable base policy at that time would have been even more contractionary. The problem was that base demand rose sharply after October 1930 as bank failures increased. So the policy would have been discredited. Bad timing.

Now suppose you propose M2 targeting in 1964, as a way of controlling inflation. The Fed says we already have inflation under control; it’s only averaging a bit over 1% a year. Then in 1979 they come back and take a second look, as inflation has risen to double digits. But soon after M2 targeting is adopted, velocity falls and you go into deep recession. And that’s just what you’d expect when inflation slows sharply. After 3 years monetary targeting is abandoned. Bad timing. M2 targeting would work better if implemented when it was not needed!

Argentina had struggled with hyperinflation for decades, and finally adopts the currency board in the 1990s. Then in the late 1990s the dollar soars in value due to the developing country economic crisis and the US tech boom, and the Argentine currency gets pulled up with the dollar, plunging them into deflation when all their competitors are devaluing. Bad timing.

The lesson is that you need to propose a robust policy, something that will work even if implemented at the worse possible time. That’s why QE alone is not enough (unless done in politically unrealistic quantities.) QE is likely to be adopted precisely when the demand for base money is soaring, indeed precisely because the demand for base money is soaring. Davies, et al, make a very good observation regarding Woodford’s NGDPLT proposal:

An inherent practical problem with NGDP targeting is precisely that it ignores that there might be, from time to time, slowdowns in potential growth. Assume that CBO’s estimate of potential output is correct, and that the Fed adopts NGDP targeting using Woodford’s proposed linear trend. If the announcement of the new policy is successful, an increase in inflation expectations would lower real interest rates, and stimulate the economy immediately. The real output gap would gradually close but, critically, inflation would initially remain below or around 2%, since according to economic theory no additional inflation is generated before the economy operates at full capacity. At the point where real GDP reaches potential, however, there would still be a large shortfall in NGDP on Woodford’s estimate of the gap. Under his NGDP rule, the Fed would then need to keep to its promise and maintain interest rates fixed at zero, pushing real GDP above its potential level and spurring high inflation. But this higher inflation would not close any pre-existing price level gap because, as we pointed out before, there is no such gap. It would instead mean that the Fed would be producing a permanently higher price level. Inflation would continue rising for as long as output remained above its potential level.

The wording here is slightly confusing, but they make an important point. If NGDP targeting aimed to close the large estimated NGDP gap from the pre-2008 trend line, then it’s quite possible it would push the economy above capacity, triggering high inflation. Davies, et al, correctly point out that Woodford probably overestimated the trend line for real GDP. But this would not be all that serious of a problem if the new policy were maintained forever. You’d have a period of above trend inflation, and then inflation would settle down to 5% minus the actual trend growth rate in RGDP. Even if it was 3% instead of 2% inflation, that would certainly not be a disaster. But here’s what might be a disaster:

There is another, even longer term, problem with this approach. Faced with rising inflation and output above trend, the Fed would eventually decide it needs to choke off the rise in inflation through raising interest rates and tightening monetary policy. This would mean pushing the economy into recession””or, at least, growth below its trend rate for a period””to generate disinflationary pressure and lower inflation expectations.

So if Woodford’s proposal to make up the entire 14% undershoot in NGDP led to much higher inflation in a few years, the policy would be politically discredited and the Fed would tighten sharply, leading to another boom and bust cycle—just what NGDP targeting was supposed to avoid. George Selgin and Larry White could correctly say; “I told you so.” It would do no good to cry and moan that NGDP targeting would have worked if only allowed to operate for 50 years. That’s not how politics works.

This is why I no longer favor returning to the old trend line, but instead favor only modestly higher NGDP growth for a few years, and then form a new trend line at what ever rate the Fed decides on. It doesn’t have to be 5%, but to play it safe I would only change the trend line very gradually. I’m a pragmatist, so I favor introducing my policy in such a way that it will do as little damage as possible, even if abandoned in 3 years. No one can assume that their pet idea will be adopted forever. That was the Achilles heel of the gold standard, a system that works far better if expected to last forever, then if faced with periodic episodes of panicky gold hoarding associated with fear of devaluation and/or abandonment of the system. The gold standard doesn’t work well if people don’t expect it to last.

PS. I have one major objection to Davies, et al. They suggest that the price level is currently right on the trend line, and that a policy of level targeting would not call for any make-up right now. I disagree. I believe that they underestimated the inflation trend up to 2008, and overestimated it since. Drawing trend lines is extremely tricky, and it’s hard to distinguish between a stable trend and one that’s changing in subtle ways. Oil prices were much higher in 2008 than a few years earlier (and then crashed in 2009); that’s why consumer prices seemed to form a “bubble” in 2008. But unemployment was close to the Fed’s estimate of the natural rate of 5.6% at the peak of the bubble, and hence their own model suggests we should have been right on trend at that time. And oil prices are still very high today! I stand by my claim that the 1.2% inflation since mid-2008 shows were have undershot on the price level over the past 4 years, and that a price level targeting regime would call for higher inflation today.

HT: Saturos

Facebook Twitter LinkedIn

Tags:

This entry was posted on October 05th, 2012 and is filed under Uncategorized. 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.



