There´s no “proper” inflation target, just a “proper” nominal spending level target

Brad DeLong writes “On the Proper Inflation Target”. After some “basis points” gymnastics he wraps up:

If you don’t mind kissing the zero lower bound when you cut interest rates by 600 basis points, you could get away with a 4%/year inflation target.

And if you don’t mind dissing the zero lower bound and do not buy the argument that the “natural” short-term safe real interest rate when the economy is in the growth-along-the-potential-path phase of the business cycle is now not 3%/year but 2%/year, then you could get away with a 3%/year inflation target.

But I do not see how you can justify a 2%/year inflation target today.

Suppose that you want a 200-basis point cushion–that you are not happy with putting your commercial banks in a situation in which their business model requires that they take huge risks to even try to cover the costs of maintaining their ATMs and their branches–and buy the 2%/year “natural” short-term safe real interest rate when the economy is in the growth-along-the-potential-path phase of the business cycle, but recoil at a 6%/year inflation target as too high? What then? Then you have to go for régime change:

  1. Reform fiscal policy so that–unlike 2008-present–it does its stimulative job to boost aggregate demand when interest rates are at their zero lower bound.

  2. Move to some form of level targeting so that the inflation target is no longer fixed, but rises and rises sharply whenever aggregate demand or the price level undershoots its previously-expected growth path.

  3. Allow the central bank to engage in expansionary fiscal policy on a large scale on its own say-so, via helicopter drops–the Social Credit solution.

  4. Move to Miles Kimball Land

I won´t consider Miles Kimball´s “e-money”. Of the other three alternatives for a régime change, two deal with fiscal policy and one with “some form of level targeting”.

But notice that inflation is still very much present, only the “inflation target is no longer fixed”! I´ll concentrate on the suggested Aggregate Demand (or NGDP) level target. The historical evidence is compelling. When the Fed manages to provide Nominal Stability, all the pieces fall into place: NGDP growth is stabilized (the essence of what I mean by Nominal Stability (along a level path), real output growth is stabilized close to “potential” AND inflation remains low and stable. In this set-up, there´s no role for fiscal policy as a stabilization tool!

The panels below, constructed as “phase space”, comparing variations (growth or inflation) in quarter t with those in quarter t+1,well illustrate mean variations and its volatilities. The periods are divided closely matching what has become known as the “Golden Age” (1960s) when the Fed was manned by ‎William Martin , the “Great Inflation” (1970s) when the Fed was manned by Arthur Burns (and G William Miller for a brief span), Paul Volcker´s (1979-87) “Transition” from high to low inflation, Greenspan´s  1987 – 05 “Great Moderation” and Bernanke´s (more recently Yellen) “Great Recession” 2006-14.

Proper Target_1


Proper Target_2

Proper Target_3

Observe that the increasingly nominal instability from the 1960s to the 1970s does not impact real growth or its (in)stability significantly, but the rising nominal instability has a strong effect on inflation.

In the more recent period (“Great Recession”) we have first a loss of nominal stability, with NGDP growth dropping strongly. Note that nominal stability has been “regained”, but at a lower average growth and not having compensated for the previous loss in the LEVEL of spending. Real growth has gone back into the “circle of stability”, also at a lower average level and inflation has been “crammed down”.

This is why many are calling the more recent period “Great Moderation 2”, but it importantly leaves out the level target. The consequence is low real growth and employment.

It is clear that to regain a “Great Moderation”, monetary policy has to place the economy at a higher trend level and then keep it there!

Update: As this just released Economist article makes clear – Politicians and central bankers are not providing the world with the inflation it needs some economies face damaging deflation instead – the focus on inflation targets is misplaced:

IT IS a pernicious threat, all the more so because, at its onset, it seems almost benign. After two generations of fighting against inflation, why be worried if the victory looks just a bit too complete, if the ancient enemy is so cowed as to no longer strain against the chains in which it is bound? But the stable low inflation fought for in the 1980s and 1990s and inflation hazardously close to zero are not so far apart. And as inflation drops, slipping into deflation becomes ever easier. It is in that dangerous position that the world now stands.

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