A last ditch defense of Inflation Targeting

You know something is in the throes of death when someone says it´s dead and someone else asks “is it really dead?”

That “something” is “Inflation Targeting”. The “someone” is Harvard´s Jeffrey Frankel and the “someone else” is the Atlanta Fed Research Director David Altig.

Although he tried, David Altig did not manage to convince me that IT is not yet dead. He brings in two “witnesses”. In another part of the statement from witness #1 – Anasthsios Orphanides – that Altig presents we read:

Taylor rule appears to represent reasonable policy and indeed, two mistakes are evident by comparing the dotted and solid lines in figure 9. Policy was easier than the rule during the late 1960s and 1970s and tighter than the rule in the first half of the 1980s. But if policy is to be evaluated based on information that was actually available when policy decisions were made, a different conclusion emerges. This is evident by comparing the dashed and solid lines in figure 9. If anything, the policy mistake of the late 1960s and 1970s is that actual monetary policy followed the Taylor rule, too closely! Rather than follow the Taylor rule, policy should have been considerably tighter. Given the mistake of following the Taylor rule in the 1970s, the deviation from the Taylor rule in the early 1980s and the policy tightening associated with the Volcker disinflation was an appropriate response to the inflation problem created by following the rule.

And from witness #2 – Roger Farmer – we get:

Volcker followed a policy of strict control of the money supply, as opposed to control of the interest rate. This policy rapidly reduced inflation at the cost of a period of high interest rates and a big spike in unemployment. In 1983, Volcker returned to a policy of interest rate control, but the implementation of that policy changed.   After 1983, the inflation-reaction coefficient increased; the Fed raised the short-rate by a larger percentage in response to inflation than it had done in the period from 1951 through 1979. The result was a period of remarkable stability in which inflation and unemployment fell, and inflation, growth, and unemployment all became less volatile.  Because of increased stability in inflation, unemployment and GDP growth that occurred after 1983, this period has been called the Great Moderation.

In my view, the monetary policy rule that was followed from 1983 through 2006 was directly responsible for the Great Moderation.

It seems the two statements are contradictory. In fact, Roger Farmer´s statement is consistent with the “consensus view”, held, among others, by John Taylor (for obvious reasons) and Bernanke himself.

Summarizing: In “the change in monetary policy is responsible for the great moderation” hypothesis many, among them Taylor and Bernanke, have attributed this “feature” to the fact that monetary policy following the appointment of Paul Volker to the Fed is characterized by an increased responsiveness of monetary policy (interest rate targeting) to inflation. This means that from the perspective of a Taylor Rule, which relates the Fed Funds (FF) rate to the difference between inflation and its “target” and the “output gap”, the coefficient on inflation has increased and was set above 1 following Volker.

As always, in economics conclusions are not definitive. So it is that research by Orphanides calls into question the shift in how monetary policy responds to inflation showing that, when using data available to policymakers in real time, monetary policy during the 1970´s was characterized by a rule that is consistent with the estimated rules for the period after Volker, i.e. the coefficient on inflation was also greater than one in the period of the “Great Inflation”.

Is there an alternative view that is able to reconcile hypotheses with data?

An alternative view of the change in monetary policy from the Great Inflation to the Great Moderation is that there was a change in the “doctrine” of the Federal Reserve. According to Robert Hetzel, during the period of the Great Inflation, the prevailing view, and the one embraced by Arthur Burns, Fed chairman from 1970 to 1977, was that inflation was a real (cost-push), and therefore non-monetary, phenomenon.

From that (Keynesian orthodoxy) perspective, the optimal combination of fiscal and monetary policy could deliver sustained real growth while “incomes policy” would be effective in containing inflation pressures that might arise! This view is clearly illustrated by Burns who argued as early as 1970 that “monetary and fiscal tools are inadequate for dealing sources of inflation such as are plaguing us now – that is, pressure on costs arising from excessive wage increases”.

Later, in different situations, he would alternatively blame, in addition to union power, oligopolists for keeping prices high and Arabs for jacking up the price of oil. Since each of these shocks could be viewed as real (cost-push) shocks, Burns denied any role for the Federal Reserve in generating inflation and repeatedly argued against a tighter monetary policy!

When placed in the dynamic Aggregate Supply (AS)/Aggregate Demand (AD) framework, this “cost-push view” as advocated by policymakers in the 1970´s suggests that the short-run AS (SAS) curve was perceived as horizontal when output is below potential.

The implication of this perceived characteristic of the SAS curve is that negative supply shocks would drive inflation higher and output lower. Given the horizontal shape of the SAS, monetary policy could successfully increase AD without generating additional inflationary pressures. On the contrary, as Arthur Burns argued following the 1973 oil shock, “a markedly more restrictive policy would have led to a still sharper rise in interest rates and risked a premature ending of the business expansion, without limiting to any significant degree this year’s upsurge in the price level”.

This “cost-push” view of inflation, together with an SAS perceived as horizontal when output is below potential, can explain the observed differences in the estimates of the parameter on inflation in the Taylor Rule during the Great Inflation and the Great Moderation.

Under the cost-push “doctrine” prevalent during the 1970´s, a forecast of inflation based on the short-run Phillips Curve (which negatively relates changes in inflation to the level of unemployment (the NAIRU – Non Accelerating Inflation Rate of Unemployment) or, positively relates changes in inflation to the output gap) would result in systematically under forecasts of inflation since after the negative supply shock output is below potential and unemployment above the NAIRU. The fact that inflation was systematically under forecast implies that estimates of the Federal Reserve reaction function as measured by the Taylor Rule using real time data that the Fed had a much stronger response to inflation than the response obtained using “final” data.

So, if during the Great Inflation the Fed did not under react to inflation, given real time data –  the error coming from a flawed forecasting mechanism – The Phillips Curve – how come the Great Moderation emerged? In other words, how did Fed “doctrine” change and why was this new “doctrine” consistent with reduced volatility in both inflation and real output growth?

On becoming chairman of the Fed, Volker challenged the Keynesian orthodoxy which held that the high unemployment high inflation combination of the 1970´s demonstrated that inflation arose from cost-push and supply shocks – a situation dubbed “stagflation”.

Volker´s challenge placed inflation as the FOMC´s top priority. He also brought to the fore of policy discussions the ideas developed during the previous 12 years – since Friedman´s address to the 1967 AEA meetings – on the importance of inflation expectations.

To Volker, the policy adopted by the FOMC “rests on a simple premise, documented by centuries of experience, that the inflation process is ultimately related to excessive growth in money and credit”.

This view, an overhaul of Fed doctrine, implicitly accepts that rising inflation is caused by “demand-pull” or excess aggregate demand or nominal spending.

Now, why is this new “doctrine” consistent with the observed increase in economic stability?

Given the cost-push “doctrine” on the inflation of the 1970´s, the Fed would compensate the fall in AS with an increase in AD, an expansionary monetary policy. This followed from the perceived flatness of the SAS curve below potential output. Since this was a flawed doctrine, over time we should observe trend growth in AD (or nominal expenditures).

Volker, on the other hand, believed that inflation was the result of excessive AD. So nothing more natural than to assume that the Fed should increase its responsiveness to the growth in nominal spending. How would this change in “doctrine” (from regarding inflation as a “cost-push” to “demand-pull” phenomenon) show up in the data?

Recall that under the cost-push “doctrine” the Fed would react vigorously to negative output gaps making policy expansionary, so nominal spending would grow. Under the new “doctrine” the Fed doesn´t react much to supply shocks since a negative supply shock, for example, would decrease real output an increase prices with little effect on nominal spending, but would react vigorously to AD or nominal spending shocks.

Therefore, under the new “doctrine”, policy would make AD growth stationary, in which case AD growth will not show a rising trend as under the cost-push “doctrine”. The chart illustrates.

The main difference between the two “doctrines” is not the change in the Fed´s responsiveness to inflation as argued by Taylor, Bernanke or Farmer, but the changed responsiveness to aggregate demand or nominal income growth. A collateral effect of the change in “doctrine” shows up in the reduction and stabilization of inflation and decreased volatility in real output.

The Fed never explicitly targeted anything – inflation or nominal income (AD) growth – but implicitly you could say it targeted nominal AD along a 5.5% growth path growth after Volker.

The chart below provides, to my mind, compelling evidence about the change in doctrine and its stabilizing consequences. One implication is that during all this time, “Inflation Targeting” was just a red herring!

And the biggest victim of the “red herring” was Bernanke himself. Since forever he has been a great defender of the “IT modus operandi” and exactly when he put it in practice he got a “depression” as the result. Worse, not satisfied, he recently made the “corpse” official Fed policy!