This post must be understood as a tribute to Nick´s and I hope the illustrations do justice to it.
In a nutshell this is Nick:
This post is for David, but it’s mostly about me. I used to think that inflation targeting was probably roughly the best monetary policy to follow. Then, a couple of years ago, I began to think that NGDP level targeting was probably roughly the best monetary policy to follow. This post is about why I changed my mind.
I could say “it’s because the facts changed”, which would be true, but incomplete. Because we always interpret those facts with theory. But it’s mostly because the facts changed.
The first bit of “theory” is this: imagine a world with no shocks, either real nor nominal, in which the central bank never makes any mistakes in hitting its target. We can imagine a world in which NGDP grows at 5% per year every year, the price level grows at 2% per year every year, and so inflation is at 2% per year every year. It’s not just that it wouldn’t matter in such a world whether the central bank chose NGDPLT, PLT, or IT; those three monetary policies would be observationally equivalent. No outside observer could tell which of those three policies the central bank was following.
We can only tell the difference between those three policies when there are real (supply-side) shocks, or when the central bank makes a mistake, and misses its target in one period.
The real world (OK Canada) looked very much like that imaginary world from around 1992 to 2008, the golden years of inflation targeting. We can’t tell which of the three policies the Bank of Canada was following, just from looking at the data. All we know from 1992-2008 data is that either IT or PLT or NGDPLT seemed to work pretty well, but we don’t know which. It took a shock to let us see the difference.
In brief, it’s because deviations of inflation from target, or deviations of the price level from the implied target, were the guard gods that didn’t bark right when we needed them to bark. And deviations of NGDP from the implied target was a guard dog that barked loud and clear.
These are the images alluded to:
And notice that the Headline CPI (or inflation) even ‘barked up the wrong tree’ (the similar pattern in the US was the FOMC´s undoing).
And the best for last:
I wasn’t an advocate of inflation targeting when it was first introduced. Hardly any economist was, IIRC; because the policy we now know as “inflation targeting” was something dreamed up by the Bank of Canada and the Reserve Bank of New Zealand largely in response to outside pressure to “tell us what it is you are actually trying to do so, so we know what to expect and can plan accordingly, and so we can hold you accountable for doing it”. We didn’t adopt IT because theory said IT was best.
Update: In the comments of Nick´s post David Andolfatto writes:
Second, as far as your “barking dogs” are concerned, I have two things to say: (a) some sensitivity analysis with your trend-cycle decompositions would be nice (start dates, in particular); and (b) there were other barking dogs in the room, namely the behavior of asset (real estate) prices (and not all barking dogs imply a role for monetary policy intervention — there is a fiscal authority out there too.)
Concerning (a), that´s an easy one. You don´t need fine instruments or even 20/20 vision. The ‘breakpoint’ is easily identified and coincides with the fact that in 1991 the Canadian government and the Bank of Canada agreed on targets for inflation reduction. NGDP ‘breaks’ a bit earlier, with that being associated with the recession that went from mid-1990 to mid-1991.
Note that the explicit adoption of IT constituted a regime change. As Nick argues it was likely successful because it was equivalent to an NGDP targeting regime. Now, to get ‘things moving back up’ it would be best to explicitly embrace the ‘dog that barks’!