Ironies galore!

In 2000, Frederic Mishkin gave the St Louis Fed Homer Jones Lecture. The title was “What Should Central Banks Do?” Mostly he talked about the Fed. From the conclusion:

Our scorecard for the Fed indicates that although the institutional set up of the Fed scores well on some criteria, there is room for improvement in others. But, is there a need for the Fed as an institution to change? The Fed’s performance in recent years has been extraordinary. It has been able to bring down inflation in the United States to the 2 percent level, which can reasonably be characterized as being consistent with price stability, while the economy has been experiencing the longest business cycle expansion in U.S. history, with very high rates of economic growth. As my son likes to say, “It don’t get no better than this.” The natural question then arises: If it ain’t broke, why fix it?

However, our Fed scorecard suggests that we do need to consider institutional improvements in the way the central bank operates. The absence of an institutional commitment to price stability, along with weak Fed transparency, which stems from the absence of an explicit nominal anchor, leaves the Fed open to political pressure to pursue short-run objectives (i.e., job creation). This might lead to time inconsistent expansionary policy and would produce inflation. In the past, after a successful period of low inflation, the Federal Reserve has “fallen off the wagon” and reverted to inflationary monetary policy—the 1970s are one example—and, without an explicit nominal anchor, this could certainly happen again in the future.

Indeed, the most serious problem with the Fed’s institutional framework and the way it currently operates is the strong dependence on the preferences, skills, and trustworthiness of the individuals in charge of the central bank. Yes, the Fed under Alan Greenspan has been doing a great job, and so the Fed’s prestige and credibility with the public have risen accordingly. But the Fed’s leadership will eventually change, and there is no guarantee that the new leadership will be committed to the same approach. Nor is there any guarantee that the relatively good working relationship that now exists between the Fed and the executive branch will continue. In a different economic or political environment—and considering the possibility for a backlash against the Fed’s lack of accountability—the Fed might face far stronger attacks on its independence and increased pressure to engage in over-expansionary policies, further raising the possibility that inflation will shoot up again.

So what should the Fed do? The answer is that the Fed should continue in the direction that it has already begun to increase its transparency and accountability. First, it should advocate a change in its mandate to put price stability as the overriding, long-run goal of monetary policy.

Second, it should advocate that the price-stability goal should be made explicit, with a numerical long-run inflation goal. Government involvement in setting this explicit goal would be highly desirable, making the Fed goal independent, which should help retain public support for the Fed’s instrument independence. Third, the Fed should produce an “Inflation Report” type of document that clearly explains its strategy for monetary policy and how well it has been doing in achieving its announced inflation goal.

The outcome of these changes is that the Fed would be moving to an inflation-targeting regime of the type described in our book, which has been recently published by the Princeton University Press (Bernanke, Laubach, Mishkin, and Posen, 1999). Clearly, the U.S. Congress and executive branch need to play an important role in encouraging the Fed to move toward inflation targeting. A detailed outline of a proposal for how this might be done can be found in our book. I leave you to read it on your own. Otherwise, you will be subjected to another full lecture.

There´s some irony here! The inflation chart shows that from the moment Mishkin gave his lecture, inflation never deviated significantly or for too long from the “imaginary” 2% “target”. Curiously that only happened after Ben (“inflation targeter”)Bernanke took over at the helm of the institution in January 2006.

Irony Galore_1

Even more ironic is the observation that as soon as the 2% target was made explicit in January 2012, inflation said its “good-bye” and it´s been almost three years since it has “gone”!

Interestingly, prior to the Fed engineered “Great Recession”, you could say either that the Fed in fact was targeting 2% inflation or that in fact it was level targeting NGDP along a 5.4% growth path. They were “observationally equivalent”.

Irony Galore_2

The depth of the crisis is very likely a consequence of the Fed losing either of the “imaginary” nominal anchors. The stated nominal anchor (2% target inflation) in January 2012 has never materialized, while the lower level path for NGDP following the crisis, along which NGDP grows at a 4% trend rate, is also in danger of being further “downgraded”, given that for the past couple of years NGDP has remained below the “revised” trend (notwithstanding Lars Christensen´s enthrallment with “the remarkably stable US post crisis NGDP”).

The story´s moral: Inflation is a very misleading target for a central bank (at least once inflation has been conquered). The real economy – employment and RGDP growth – would be much better off if the Fed chooses an NGDP level target as its nominal anchor. In that event, inflation would simply not be an issue!

PS I know the inflation target refers to the headline PCE. But the inflation trend is much better indicated by the Core PCE.

One thought on “Ironies galore!

  1. Gee, I thought a macroeconomic policy-making body should be concerned with sustained robust economic growth.

    We find out from Mishkin that a flat rate of inflation, as measured by a subjective index, is far more important then robust economic growth.

    This has to be one of the more demented speeches ever made, some sort of theo-monetarism masquerading as economic thought.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s