Inflation targeting as voodoo economics

A James Alexander post

My last post was on the need to change the 2% inflation target to higher one or, better still, switch to  NGDP growth targeting. However, by even talking about inflation I feel it is easy to get sucked into a black hole of nonsense chatter about a concept so hard to practically measure.

Nominal GDP (as measured by the value of output, total income or total expenditure) is the reality. Real GDP is a highly artificial construct. And inflation is also a highly artificial construct, the mere residual between the reality of actual Nominal GDP and the artificial Real GDP. It is necessary to calculate some version of inflation to get from real Nominal GDP to artificial Real GDP.

To create a Real GDP figure the statisticians are meant to collect a huge number of price indices for each product, and then deflate the real or actual nominal value of output (ie sales) to derive a supposedly inflation-free “real” but artificial output figure.

Although they collect all these price indices they don’t create indices for the changing quality of each product. They should do. The price indices are thought of as “inflation”, but that is because of the assumption that the inflationary element of prices changes more quickly than quality or nature of the goods and services change. But how do we know? Has it been tested? Has it even been thought about in any methodical manner. I don’t think so. Occasionally, hedonistic or quality changes are incorporated into the price indices, but in a highly haphazard way. Statisticians do track changes in the basket of goods and services via surveys or by observing actual patterns of expenditure but can’t track changes in the nature of service – like a switch from learning on the job to learning at college, or a switch from spending on alcohol to spending on a gym, vice to virtue.

Of course, any quality or nature indices would create huge debates. But the price indices are largely meaningless without them. How can price inflation be observed without as much monthly effort going in to assessing the quality and nature of the product or service being tested.

Entertainment is the classic example, 15% of the CPI basket. The switches from street entertainers, to theatres, to movie theatres, to black and white television, to colour television, to broadband internet all involved major changes in product quality and very often the fundamental nature of the service. The pure inflation element may be able to be measured from one week to the next, but quality and nature also move ahead rapidly.  Transport, another 15%, is the same as walking gave way to horse drawn transport, to railways, to motor vehicles, to aircraft, to not travelling but having people and products brought to you virtually. The cost is not then transport but the cost of the broadband connection. Restaurants and hotels, 10% of the basket, change in quality all the time. Housing provokes similar questions.

I am not denying it is quite hard to compile NGDP as it has one or two theoretical issues itself: the final vs intermediate consumption issue, the issue of how to value self-owned housing or the scale of the informal economy. But RGDP has the exact same issues, plus the massive issue of divining pure inflation from changes in quality and nature.

Paul Krugman likes to throw the “voodoo economics” tag around when non-mainstream economists come up with ideas, but what should be done when mainstream economics has formed a consensus   around a very silly idea like inflation targeting.

The 2% target is voodoo upon voodoo

On top of the targeting of inflation, seemingly out of thin air a 2% target was created. It was possibly invented because the long run real growth has often been calculated as around 3%. So a 2% inflation seemed a nice balance. Not more than real growth, but not too close to zero and risking deflation. Not too high as to upset the current bunch of Republicans, the Germans, the famous Japanese housewives, or …? William Dudley of the NY Fed recently gave as a reason that it meant most people in their 30 year working lives would see a doubling of prices. Assuming inflation can be so precisely calculated, so what? Why not no change or quadrupling? What difference can it make?

Why has inflation targeting appeared to have worked?

There is much discussion about the “divine coincidence” that while targeting inflation, central bankers actually targeted the output gap. And during the Great Moderation got monetary policy more or less right. The “output gap” is an even more tricky theoretical concept.

NGDP Targeting is so sensible, so simple. It does not rely on any theoretical concepts to target like inflation, RGDP or another voodoo upon voodoo concept like the gap between artificially-created RGDP and where the artificial RGDP should be, theoretically speaking.

Some have suggested that central bankers were implicitly targeting NGDP growth. Well, maybe. If they were, it came very unstuck in 2007-08 when they seemed blinded by high headline inflation, and were very slow to react to falling actual NGDP growth and crashing NGDP growth expectations.