If there is something that radically changes when a recession described by a fall in aggregate demand (or NGDP) takes place it is the concept of inflation. In situations of economic normality – full employment and capacity utilization – inflation is something undesirable in that it increases interest rates, discourages savings and induces distortions in the allocation of capital.
However, in the present situation characterized by a high rate of unemployment and aggregate demand far below an adequate level, it is said that the economy needs more inflation! Suddenly, a higher inflation or, more precisely, an increase in inflation expectations becomes something “good” for the unemployed and for economic growth.
It is not surprising, therefore, to witness a great confusion in the discussions, not only in the media but also among FOMC members themselves. For example, in all the eight FOMC meetings of 2010 Thomas Hoenig, president of the Kansas City Fed, cast a dissident vote. That was a record!
The concept of inflation is confusing. It is certainly important, but what is its correct measure? The chart below shows some of the differences by comparing the deflator for personal consumption expenditures (PCE) in its “headline” and “core” versions. The “core” version excludes from the “headline” index the volatile components such as food and energy.
Maybe the best that can be done is to altogether stop talking about inflation and, more importantly, not take it into consideration during the FOMC meetings to establish monetary policy. Instead of inflation, the goal, or target of monetary policy should be the growth of nominal spending along a determined growth level path.
There are several advantages to adopting a NGDP level target:
- If the goal is to stabilize aggregate demand monetary policy does not prompt undesired fluctuations in real output in the case of real (or supply) shocks.
- It allows the widening of the focus of policy to take into account monetary aggregates, asset prices, yields, etc., thus diverting the obsessive attention dedicated to interest rates, which tend to be a poor indicator of the stance of monetary policy, revealing a more clear picture of the economy´s health.
- As many prices are sticky, a fall in nominal spending doesn´t immediately show up in the inflation numbers. Therefore, the behavior of nominal spending is a better indicator of monetary shocks than inflation indicators such as the CPI or the PCE. On the other hand, if a significant price shock takes place – a jump in oil prices, for example – the “headline” inflation indices are going to rise. With policymakers focused on inflation, especially on “headline” inflation, they will miss the underlying weakening of the economy. This is, for example, what happened in 2008 as I illustrate.
As the chart shows, the oil shocks of 2003-06 and 2007-08 were of similar magnitude.
In both instances “headline” inflation went up. More so on the occasion of the second oil shock, maybe because it was more concentrated in time and because it came on the heels of the previous one.
Note that while the FF rate was on the rise during the first shock it was falling during the second, with the FF rate being lower in early 2008 (3.2%) than in late 2005 (4%). Nevertheless, monetary policy was tighter in 2008 than in 2005. Why do I commit such “blasphemy”? Just note what was happening to nominal spending on the two occasions. The chart below shows that, despite the oil shock, while in 2005 nominal spending remained on the trend associated with the “Great Moderation”, in 2008 it dropped below before tanking in the second half of the year.
So, ignoring nominal spending and concentrating on confusing and conflicting inflation signals, the Fed, in effect, tightened monetary policy.
Furthermore, since in the last decades all the talk was about reducing and controlling inflation, to start talking about increasing inflation or inflation expectations sounds very strange and leaves everyone confused. It seems, therefore, that from a “public relations” perspective it also sounds better to talk about increasing nominal incomes or spending!
Update: This piece in the WSJ is a case in point (HT:Patricia Stefani):
The double think, deception and distortion of the cold-war era looks like it’s being reproduced today. Except, unlike then, when it was state trying to manipulate state, now it’s central banks manipulating individuals and markets.
Nowhere is this more clear than with respect to inflation. Central bankers are trying to convince people that they will turn a blind eye to inflation in order to cut people’s very high preferences for holding cash and liquid assets. These extreme liquidity preferences are, according to standard economic thinking, causing a deficit in demand.
Unfortunately, the same central banks spent the past three decades convincing people that they will do whatever it takes not to allow a repeat of the rampant inflation that made the 1970s an economic wasteland.
What to do?