Japan doesn´t need a higher inflation target, but a sufficiently high NGDP Level Target

In his Bloomberg View article today, Narayana Kocherlakota writes “A Possible Cure for Japan’s Low Inflation”:

Suppose, for example, that the Bank of Japan had announced a target of 4 percent in March 2013. Actual inflation over the past three years would probably have been higher — teaching wage-setters and price-setters that if they want to avoid costly mistakes, they’d better pay attention to what the central bank says will happen. Having built up that credibility, the central bank could then more easily guide expectations to its long-run goal of 2 percent.

Before Abe, Japan had an implicit 0% inflation target. By establishing an explicit 2% target, things should have worked out as Kocherlakota argues. But they didn´t! Does that mean that if you really want 2% inflation you should target 4%? Doesn´t sound reasonable.

As the chart indicates, Japan´s problems began when the BoJ allowed NGDP to stagnate. It appears it would be much more effective for Abe/Kuroda to stipulate that the BoJ would “not rest” until nominal spending (NGDP) had reached the stated level, from which it would henceforth grow at a specified rate.


Kevin Erdmann Writes One of the Most Important Blog Posts of The Year

A Benjamin Cole post

Kevin Erdmann, of blog Idiosyncratic Whisk, has written extensively and persuasively about housing costs and inflation, but lately topped himself when addressing wages.

Erdman in his Sept. 9 post, Real Wage Rates and Tight Labor Markets, takes a look at “quit rates,” and concludes quitters, probably better referred to as “job hoppers,” get higher wages. The quitters move into jobs in which they are more valuable to the employer.

So wages in general can rise, but productivity rises too. “This is why the relationship between real wage growth and inflation is not strong,” says Erdmann.

Erdman further ponders the scene, and concludes, “In any case, it seems as though the overwhelming factor for positive outcomes [for both business and labor] is stability. That seems to be associated with inflation rates in the 2% to 4% range. Stability will be related to low unemployment and low risk premiums. The risk to our economy of wage growth, if there is any risk at all, seems greatly overshadowed by the risk of business cycle instability.”

Yeah, you know, snuffing out an economic recovery to fight minor wage growth is a bad trade-off.

Erdmann notes that present-day wage hikes are below 1990s levels even yet, btw. I note that Q2 saw unit labor cost deflation, as measured by the Bureau of Labor Statistics.

The Frantic Fed

The Fed, as widely observed, seems to be in a heightened, frantic, even hysterical state of prissiness regarding the possibility that inflation might migrate back up towards its 2% target (which evidently even Fed Chief Janet Yellen forgets is an average target, not a ceiling).

Even worse, the empirical evidence that 2% is a good IT is seriously wanting. As I have oft-noted, from 1982 to 2007 in the United States, the average inflation rate in the United States (CPI) was just under 3%, and real growth just north of 3%.


Q: Given the historical record, and the observations of Kevin Erdmann, what makes a 2% IT attractive to central bankers?

A: They can undershoot it and be close to zero, their real goal.


What if a 3% average inflation is a better central bank IT (let alone NGDPLT)?

Could the Fed ever alter its IT? Could the Fed go to an IT-band, such as that of the Reserve Bank of Australia?

Have American policy-makers and central bankers become so inflexible, so hidebound, so PC, that a moderate increase in the IT is not possible?

And if a moderate increase in the IT is not possible with independent central bankers, is independence a good idea?

How to avoid sunburn, or the sorry state of UK monetary policy

A James Alexander post

When Mark Carney was appointed Governor of the Bank of England back in 2012 hopes were high. The Bank of England was mired in failure. For Market Monetarists it had a poorly understood monetary policy that could and should have been more proactive in 2007-2009 that directly led to the UK’s experience of the Global Financial Crisis being so much worse than most other countries. Whatever the cause, the BoE had totally failed to ensure financial stability. Somewhat surprisingly, it actually got more powers as a result of the crisis rather than less. Perhaps the price of gaining more power was that an outsider had to be appointed Governor to reform the Bank.

Carney certainly started with a bang. He made his famous speech on Guidance in late 2012 while still basking in the glow of being Governor of the very well-regarded Bank of Canada. The Canadian central bank had had a good crisis, although this was not really much to do with Carney who had been appointed only in February 2008. While he acted as a decent firefighter, drawing on his time in investment banking, the principles of flexible inflation targeting and tight banking regulation had been established for a couple of decades.

Much new blood has since been brought on board and there has been a major internal shake up. But has anything really changed? Not by the evidence of this woeful article by one of Carney’s new faces Kristin Forbes.

“As the summer holiday season begins and the date of an interest rate increase draws nearer, this is a good time to remember the importance of timing.

With both sunshine and inflation, there is a peril to living only in the moment. One should plan for the future – especially if precautionary actions take time to be effective. But it is also important to monitor last-minute changes in the weather forecast – or in the economic outlook – and adjust your plans accordingly.

We all know the enjoyment of that first day on holiday. It is tempting to stay outside all day – whether you prefer to doze, read a good book, or go for a swim or for a long run. But linger too long in the sun and your skin may take on a slightly pink glow.

While you probably won’t want to move from your comfortable spot in the sun, if you ignore the warning signs you may have a painful sunburn that evening. Yes – you can treat the sunburn, but it might spoil the rest of your holiday. Better to take preventive action.”

Is there where the level of monetary economics has got to at the Bank of England? Maybe the elite macro specialists on the MPC have to dumb down to get their point across to the readers of the Daily Telegraph but this is ridiculous. Ridiculous and wrong.

Wrong because the BoE appears to have learnt nothing from Japan’s decades of failed monetary policy. Creating a 2% ceiling and constantly threatening to raise rates any time there is the faintest whiff of prices rising ensures you will never come close to the 2% target. The market automatically tightens policy with its reaction to “good” economic news by raising short term rate expectations and by buying the currency. This tightening slows the nominal economy. “Bad” news then becomes good from prospective loosening of policy – the currency weakens and short term rate expectations fall back. Repeat.

These rapid market reactions show that Forbes is just wrong about lags. It is very tired, old school, thinking indeed:

“But unfortunately monetary policy works with lags much longer than a sunburn affects your skin. An increase in interest rates is generally believed to take somewhere from one to two years to have its maximum impact. Maintaining interest rates at the current low levels during an expansion risks creating distortions.”

Wrong because the underlying concept of “full capacity” causing inflation has been falsified for many years. Monetary policy causes inflation, or rather, nominal growth, not full employment. It is perfectly possible to have full employment without inflation. The long-run Phillips Curve is vertical – the somewhat painful lesson of the 1970s stagflation. At very low levels of inflation the Phillips Curve does, in the short-run, well, curve, due to downwardly sticky wages.

Wrong because even on their own terms of Inflation Targeting UK inflation is dead in the water. Forbes’ claim this is simply false

“Much of the weakness in core inflation can be explained by low energy prices and sterling’s strength, suggesting that core inflation should begin to recover from current low levels as last year’s sharp fall in energy prices rolls off.”

The Daily Telegraph helpfully supplies some charts in its article reporting on Forbes’ comments showing exactly what is going on with inflation.

Wrong because there is so little evidence presented for the damage to the economy from waiting too long. it is just asserted continually by hawks regardless of the dangers in acting too soon, a much bigger issue as the ECB so painfully found out in 2011 when it caused the second leg of the Eurozone crisis via the two rate rises.

“Therefore, interest rates will need to be increased well before inflation hits our 2pc target. Waiting too long would risk undermining the recovery – especially if interest rates then need to be increased faster than the gradual path which we expect.”

The phrase “well before” tightened policy the moment it was read, judging by the moves in Sterling overnight. It is scary that our MPC members can be so irresponsible.

Of course, she also raises the bogeyman of wage-push inflation still surprisingly current in central bank circles by worrying about wage growth. This stance is especially cruel on the mass of the population as it will ensure no real wage growth over the medium term, and probably no falls in inequality as it seems that the low paid suffer more from a weak labour market than the higher paid. The current modest uptick in wage growth to something still below the good but not great growth rate of the Noughties is something to be nourished not crushed, The danger the MPC seems oblivious to is that even talk about crushing it will kill it.

All these common mistakes seem to flow from the addiction to Inflation Targeting. Ultra-low inflation is not and never should be an end in itself. Prosperity is the end we all should seek. If ultra-low inflation conflicts with prosperity then the Inflation Target should be ditched. To be fair to Forbes she is mostly parroting Carney – more shame on him!

The ECB will not change strategy, even if that means marching towards and falling-off the precipice!

The European Central Bank can’t change the fundamental goal of its monetary policy, even in times that call for extraordinary measures, said European Central Bank Executive Board member Yves Mersch in remarks published Monday.

“What anchors trust in the central bank is that our objective and strategy stay constant–and this is even more important when monetary policy becomes more unconventional,” he said. “For this reason, innovative ideas to change our strategy, such as targeting a price level, would in fact be counterproductive in the current environment.

The ECB´s target is an inflation rate close to but slightly below 2%. From 1999 to 2007 they did an almost perfect job, with inflation averaging 2%. Over the last few years, however, inflation has been on a downtrend and has recently even become negative!

The chart shows what happens under the IT and PLT alternatives. Given that the price level has fallen significantly below the 2% trend line from 1999, if, as Mr Mersch prefers, the ECB keeps to its IT strategy, the price level will be permanently lower. This means that the ECB will not be ‘penalized’ for having missed the inflation target for a long time. It´s sufficient that from now on it hits it!


Adopting a price level target, on the other hand, would force the ECB to offset its previous error. Temporarily, inflation would be higher than 2%, which, in any case, is exactly what´s needed!

It would be even better if, instead of a price level target the ECB adopted an NGDP level target, but that would be asking too much from such a conservative body.

A long-time Fed economist discusses NGDP favorably

Robert Hetzel, of the Richmond Fed writes “Nominal GDP: Target or Benchmark?”  I highlight two passages.


Previous work by the author in 2008 and 2012 argues that former Fed chairmen Paul Volcker and Alan Greenspan followed a nonactivist rule during the period known as the Great Moderation, the years following the Volcker disinflation through the Greenspan era. Although the FOMC does not explain the rationale for its policy actions within the framework of a rule, since this era, policymakers have recognized the need to behave in a consistent, committed way to shape the expectations of financial markets.

The chart provides the view of NGDP growth and inflation for the last 60 years.

Hetzel Benchmark_1Hetzel Benchmark_2

Initially NGDP growth is highly volatile (but trendless). From the mid-60s to 1980, NGDP growth trends up, and so does inflation. The Volcker adjustment was a period when NGDP growth was strongly reduced with inflation being brought down significantly.

Note that from the start of Greenspan´s Great Moderation, NGDP growth is stable, but inflation continues to come down, only reaching the (implicit) 2% target in the mid-90s.

As Hetzel notes, the Fed, particularly Greenspan, never explained the rationale for its policy actions within the framework of a rule. As such, the Taylor-rule was an attempt by John Taylor to describe (guess, make-up) a “rule” that was consistent with what the Fed was doing. With time, given the highly successful monetary management of that period, Taylor and his followers want us to believe that the “rule” was responsible to the period´s success!

From the chart, it appears much more likely that the “success” (defined by inflation falling and remaining low and stable) was mainly due to NGDP growth remaining stable.

The chart on RGDP growth tends to corroborate that view.

Hetzel Benchmark_3

Throughout the 1954-2007 period, RGDP growth averaged 3.4% (we´ll see below that is true since 1870!). Before the mid-60s, the volatility of RGDP growth is due to the volatility of NGDP growth. During the “Great Inflation”, RGDP growth volatility derives from the inflation volatility of the period (caused by the rising and “chopped” growth in NGDP). During the “Great Moderation”, low NGDP growth volatility translates into low inflation and real growth volatility!

Which leads me to the second passage of Hetzel´s essay I want to highlight:

If trend real GDP growth is stable and policy is credible so that the expectation of inflation is aligned with the FOMC’s inflation target, as it was for most of the 1990s, these procedures translate into stable trend nominal GDP growth. Note, however, that this fact does not imply that the FOMC had a target for nominal GDP.

It would seem that a stable NGDP growth is the outcome, or result, not the driver! That´s the reason for him to suggest that NGDP may be a good benchmark (although not a target).

My first observation is that trend real growth has been stable since the 19th century! It´s not a characteristic of the 1990s. The top chart shows RGDP and trend from 1870 to 2011 (yearly data). Trend growth is 3.4%. The bottom chart, based on quarterly data from 1954 to 2014, shows that trend growth is also 3.4% (up to 2007). Note that following the Great Depression, RGDP reverted to trend. Will the post 2007 period become known in 50 years’ time as “the Bernanke Break”?

Hetzel Benchmark_4

Hetzel Benchmark_5

My second observation is that during the 1990s, since the US did not have an explicit inflation target, policy credibility cannot be defined as the “alignment of inflation expectations with the FOMC´s inflation target”. The FOMC´s “target” was “low” inflation, something vague. In the course of the 1990s, the Fed gained credibility because inflation remained “low”. My conjecture is that that´s the outcome of NGDP growth evolving stably along a level trend path.

The panel below indicates my conjecture has some validity. From the early 90s to early 2008, you could say the Fed “targeted” inflation, not at 2% but in a band of 1% – 2%. You could also say it targeted the price level (PLT) close to a 2% trend growth, but you could also say the Fed targeted NGDP along a 5.5% trend level path.

Hetzel Benchmark_6

The “Bernanke Break” serves to show that what “held everything together” was keeping NGDP evolving stably along a level path. In 2008 it wasn´t inflation or the price level that indicated something was wrong. The “dog that barked” was NGDP dropping significantly and “permanently” below the trend path!

But by all means, if there are reservations to a formal NGDP level targeting, use it as a benchmark. If the Fed had done so in 2008, things would be much less dire in 2014, and we would not be having ridiculous discussions about “GSG”, “SS” or about “June”, “September” or “whatever”! Or see things go topsy-turvy as suggested by this piece by Binyamin Appelbaum ( HT Peter Ireland):

At a hearing in February, Representative Scott Garrett, a New Jersey Republican, complained that Congress and the Federal Reservehad traded places.

During previous periods of high unemployment, members of Congress pressed the Fed to print more money even as the Fed remained wary of the inflationary consequences of such efforts.

After the Great Recession, by contrast, the loudest criticism has come from politicians demanding that the Fed shut down its printing press and raise interest rates.

Raise the banner! Oops, I mean the Inflation Target!

The higher IT idea has never died, and recently there has been a “great revival”. Cecchetti and Schoenholzt have a long post – Is 2% still the solution?” – but the conclusion comes on the third paragraph:

The debate over the appropriate level for a central bank’s inflation objective reminds us of a 40-year-old Sherlock Holmes movie called “The Seven-Per-Cent Solution.” Convinced that Holmes’ addiction to cocaine (the solution in the title) had made him delusional, Watson took the master sleuth to Vienna to be treated by Sigmund Freud.

Has the 2% solution for inflation targeting in advanced economies made central bankers similarly delusional? Are they stubbornly attached to an outdated target? That argument gained ground in recent years as policymakers in Europe, Japan, and the United States struggled to stimulate weak economies and stabilize prices with policy interest rates stuck at the zero bound.

Our view is that if policymakers could start from scratch, they might well choose a somewhat higher inflation target. Their rationale would be to avoid having to lower the policy rate to zero again in a future recession. But the cost of changing the policy framework now would be a substantial loss of credibility, so there seems little chance for a new regime with a higher inflation target.

Tony Yates, who has been pushing the “raise the banner” idea lately, comments on C&S:

On this central point [the credibility issue], I don’t think we can know.  This is the sort of thing central bankers and ex-central bankers [Steve being one!] say a lot.  But there isn’t any good theory or empirics of reputation formation and dissolution, so we are in the dark.  I remember thinking it rather wishful thinking that inflation targeting – simply promising to create the amount of inflation you wanted – would be believed, especially after a few decades of failed proper [read ‘intermediate’, ie exchange rate/monetary] targeting.

I would also like to re-emphasize a point I made in my earlier post, that worrying about credibility is the right thing to do, but might cause us to be concerned about the status quo.  If unconventional monetary policies are not as effective, or more costly to wield than interest rate policy, and if there are insurmountable political obstacles to using discretionary fiscal policy, then too-low inflation means more busts than we thought.  And a higher risk of being trapped forever at the zero bound.

Krugman, one who has never let go of the higher inflation target idea, comments on a very interesting series of posts by Mathew C. Klein on the 2009 FOMC Transcripts:

Matthew Klein has been going through Fed transcripts from 2009, and notes that the Fed was surprised at the persistence of inflation despite the Great Recession. Oddly, however, he seems to suggest that this episode weakens the case I and others have been making for a higher inflation target. Actually, it strengthens that case.

And concludes:

So the failure of inflation to fall as much as predicted in 2009 was part of a series of events that were trying to tell us that the initial inflation target was too low.

I think the “higher IT” debate is a complete waste of time and effort. Over many years, even decades in some cases, inflation was kept low and stable, both for countries formally targeting inflation, either point targeting at 2% or targeting within a narrow band centered at 2%, and for countries, like the US, who had no numerical target, just a concept of what “price stability” meant (according to Greenspan, it was a rate of inflation that didn´t affect people´s plans).

My conjecture is the “good times”, or “Great Moderation” experienced by many countries, many times beginning in the mid-1980s and extending to 2006-07, has mistakenly been credited to IT, even if it was, like in the US, only informal (or implicit). What was really behind the “good times” was the accomplishment, by many central banks, of nominal stability, a much more encompassing concept.

In fact, the IT idea emerged, “out of the blue”, in the late 1980s, when the New Zealand government was seeking to improve general government performance and began giving departments and agencies clear goals by which they could be appraised.  I can just imagine what went on in the head of the RBNZ Governor when asked how he should be evaluated. Seeing that inflation was falling after being in the two-digit range for many years, his quick answer must have been something like “keep inflation low”. Thus was born IT!

That doesn´t give IT a good “pedigree”. Nevertheless, academics were quick to develop theoretical and model-based frameworks that gave IT the “pedigree” it needed to flourish. So why is it that at present there´s so much discussion on “regime change”?

Great minds predicted this. More than a decade before IT “emerged”, Nobel Laureate James Meade in his 1977 Nobel Lecture called IT dangerous:

Earlier I spoke of ‘price stability’ as being one of the components of ‘internal balance’. Yet in the outline which I have just given of a possible distribution of responsibilities no one is directly responsible for price stability. To make price stability itself the objective of demand management would be very dangerous. If there were an upward pressure on prices because the prices of imports had risen or because indirect taxes had been raised, the maintenance of price stability would require an offsetting absolute reduction in domestic money wage costs; and who knows what levels of depression and unemployment it might be necessary consciously to engineer in order to achieve such a result? This particular danger might be avoided by choice of a price index for stabilisation which excluded both indirect taxes and the price of imports; but even so, the stabilisation of such a price index would be very dangerous. If any remodelled wage-fixing arrangements were not working perfectly, – and it would be foolhardy to assume a perfect performance – a very moderate excessive upward pressure on money wage rates and so on costs might cause a very great reduction in output and employment if there were no rise in selling prices so that the whole of the impact of the increased money costs was taken on profit margins. If, however, it was total money incomes which were stabilized, a much more moderate decline in employment combined with a moderate rise in prices would serve to maintain the uninflated total of money incomes.

Flash forward thirty years to 2007 and the “danger” materializes under Bernanke Chairmanship of the Fed. And this mostly happens because Bernanke was known as an ardent defender of inflation targeting and would likely act accordingly.

Later in the Lecture Meade proposes NGDP Level Targeting

I have told this particular story simply to make the point that the choice between fiscal action and monetary action must often depend upon basic policy issues which should certainly be the responsibility of the government rather than of any independent monetary authority. Perhaps the best compromise is an independent monetary authority charged so to manage the money supply and the market rate of interest as to maintain the growth of total money income on its 5-per-cent-per-annum target path, after taking into account whatever fiscal policies the government may adopt. One would hope, of course, that there would be a suitable discussion of their plans and policies between the government and the monetary authority; but the latter would be given an ultimately independent duty and independent choice of monetary policy for keeping total money incomes on their target path.

Among the suggested “new regimes”, NGDP Level Targeting stands out. Why so much interest in NGDP Level Targeting?

To me, one important, maybe even defining, reason is that over the whole of the pre 2008-09 crisis “inflation targeting period”, including all the non-IT central banks, like the Federal Reserve, that nevertheless managed to keep inflation low and stable, all the “targets” (NGDP-LT, IT and PLT) were observationally equivalent.

To illustrate I look at Canada, an inflation targeter and the US, which did not target anything explicitly.

IT Banner_1

IT Banner_2

For both countries before the crisis, NGDP growth trend is 5.4% while both Headline and Core inflation are approximately 2% in the two countries.

Note that up to the moment the crisis hit, you wouldn´t be wrong to think, if you didn’t know otherwise, that both countries could be doing either IT, PLT or NGDP-LT. There´s no way to distinguish among the alternatives.

What the crisis showed is that inflation or price level targets are not robust, or dependable, “target rules”. If an NGDP-LT target had been explicitly pursued, both the Fed and the Bank of Canada (and many other central banks) would have heard the “dog bark” loud and clear! (Note that the IT and PLT “dogs” “barked up the wrong tree”!)

In fact, inflation targeting is not something that naturally defines central bank procedures. If you contrast New Zealand and Australia, for example, you´ll learn that macroeconomic outcomes other than inflation can be widely different even for inflation targeting central banks.

This adds to Ball and Sheridan´s findings in their 2003 article “Does Inflation Targeting Matter?” that since the early 1990s inflation has been lower and more stable in both IT and non-IT countries.

Ball and Sheridan´s findings are consistent with the idea of observational equivalence between IT, PLT and NGDP-LT that I illustrated using Canada and the U.S. From this, one could infer that low and stable inflation countries followed a de facto NGDP-LT targeting. The crisis had the effect of revealing the actual targeting regime.

A country such as Australia, where NGDP remained close to trend is more likely to have been following a NGDP-LT targeting regime than Canada or the U.S., where NGDP dropped well below trend.

Another inflation targeting country that the crisis revealed was de facto targeting NGDP is Israel. The contrast between Israel and the U.S. clearly brings out the danger of IT alluded to by James Meade. Although the U.S. was not formally an IT country, when Bernanke took the helm at the Fed in early 2006, it got much closer to being an IT country.

The different reaction of each Central Bank to the oil shock explains the different outcomes. While an oil shock (a negative supply shock) increases inflation and reduces growth, those effects tend to be temporary and the best monetary policy can do is to keep nominal spending close to trend. The charts show that by doing exactly that Israel avoided the real output contraction that befell the US and other de facto IT countries.

IT Banner_3

IT Banner_5

IT Banner_4

The German-centric ECB is arguably the most ardent IT central bank. For market monetarists, who strongly favor NGDP-LT, it is not surprising to observe the dramatic results, with the region going into deflation and real growth being close to zero and negative for some individual countries.

The chart below removes any doubt one may have on the dangers of inflation targeting in the face of supply shocks.

IT Banner_6

In the chart we observe the dramatic consequences of the ECB tightening in reaction to the rise in oil prices in 2008 and again in 2011.

Given the evidence I find Carl Walsh´s conclusion in his 2009 paper “Inflation Targeting: What Have we Learned?” depressing. To Walsh:

Financial meltdowns, such as the United States is experiencing at the time this is written, pose similar problems for IT and non-IT central banks. In that sense, they are irrelevant for the inflation targeting debate…

They certainly are not irrelevant. Countries, be them inflation targeters or not, that were on a de facto NGDP-LT regime fared much better than the de facto inflation targeters. And the reason is straightforward. NGDP-LT provides a much higher degree of nominal stability to the economy, and thus is much more effective in limiting the propagation of real shocks.

Therefore, instead of “suggesting” a higher target inflation, economists should try to help central banks “rediscover” nominal stability. For that, finding the appropriate level of nominal spending is required. It is not enough to just keep nominal spending growing at a stable rate, as the US has mostly done since emerging from the crisis.

PS An expanded version of this post can be found in “Which is more reliable” (PDF)

The “(Stan) Fischer Effect”

In 1995, while a managing director of the IMF, Stanley Fischer wrote an essay titled: “Modern Central Banking”, where he ardently defends “Inflation Targeting” (The NBER version is here):

…The issue of a target price level (PLT) versus target inflation rate (IT) nonetheless remains. Compare the goal of being close to a target price level that is growing at 2% per annum from a given date, say 1995, with the goal of achieving a 2% inflation rate each year from 1995 on.

With a target price path (PLT), the monetary authority attempts to offset past errors, thus creating more uncertainty about short-term inflation rates than with an inflation target (IT). The gain is more certainty about the long-term price level.

My present view is that the inflation target with its greater short-term inflation rate certainty is preferable, despite its greater long-term price level uncertainty.

I thought that view was “narrow-minded”, in particular given that important firm and individual decisions tend to be longer term ones. Does Fischer still hold those views from 20 years ago?

By 2011 he had come to favor a flexible IT regime:

“A central bank should aim to maintain price stability and support other goals, particularly growth and employment. So long as medium-term price stability — over the course of a year or two or even three — is preserved.”

Price stability means 2% inflation. But for at least six years inflation (as measured by PCE Core prices) has been well below target except for a fleeting moment in early 2012, coinciding with the moment the 2% target was made official. Barring people like Bullard who think the “Core is rotten”, most people think core prices provide a better indication of the inflation trend. (The chart indicates how fickle the Fed would be if it targeted headline inflation at 2%!)

Stan Fischer Preferences_0

So by Fischer´s own definition we haven´t experienced “price stability” for several years, implying a lot of uncertainty about “short-term inflation rate certainty”.

In fact, “long-term price level uncertainty has been lower than short-term inflation uncertainty”, especially if you associate the price level with the core measure of the PCE.

As the panel below shows, core prices evolved very close to trend until 2012, after which they fall a little short. The headline price level was impacted by the persistent oil shocks during 2003-08. More recently, the negative oil shocks have brought it back to trend. Meanwhile, core inflation has spent most of the time below the target (initially implicit) level.

From a PLT perspective, the Fed is doing OK. From an IT perspective, it is doing a pretty awful job. But note that trying to “correct” inflation (bring it to target) will likely “disturb” the PLT (at least the headline price level). But the Fed doesn´t target the price level!

In 2008 the Fed botched the job because it became “afraid” of the increase in headline inflation that was rising on the heels of oil prices. That shows the main deficiency of both IT and PLT. Both are sensitive to real or supply shocks. Since the Core measure of the price level is much less sensitive to supply shocks, the fall in the core price level below trend over the past few years is an indication, contrary to FOMC conventional wisdom, that the drop in inflation is due to more than recently falling oil prices! Would that be related to a monetary policy that is implicitly tight?

On that score, the panel also shows that the major factor behind both the depth of the recession and the weak recovery was the Fed letting nominal spending drop way below trend and then not allowing it to climb back towards trend, i.e. keeping monetary policy too tight!

The NGDP & Trend chart is also evidence that the prevalent view that monetary policy was “too easy” in 2002-05 is misguided. With the FF rate at 1%, in August 2003 the FOMC decided to undertake forward guidance. All measures of inflation were below the target, and so was the NGDP level. It was effective in bringing both NGDP and core inflation back to target (headline was impacted by oil, and that shouldn´t concern the stance of monetary policy).

Bernanke took over with a “clean slate”! And proceeded to botch the job!

Stan Fischer Preferences

Unfortunately, those responsible for monetary policy simply won´t recognize the need for an overhaul in how monetary policy is conducted. Simply “endowing” the inflation target with more flexibility, imposing interest rate rules (aka “Taylor-type” rules) or even adopting a PLT won´t cut it. One of the consequences of this “hard-headedness” will be increasing claims for the use of distortionary fiscal policies (“stimulus”).

Unfortunately as he has made abundantly clear over the years, Stanley Fischer is quite against it, although he left a door open in a 2011 speech called “Central Bank Lessons from the Global Crisis”:

During and after the Great Depression, many central bankers and economists concluded that monetary policy could not be used to stimulate economic activity in a situation in which the interest rate was essentially zero, as it was in the United States during the 1930s – a situation that later became known as the liquidity trap.  In the United States it was also a situation in which the financial system was grievously damaged.  It was only in 1963, with the publication of Friedman and Schwartz’s Monetary History of the UnitedStates that the profession as a whole1 began to accept the contrary view, that “The contraction is in fact a testimonial to the importance of monetary forces.”

In this lecture, I present preliminary lessons – nine of them – for monetary and financial policy from the Great Recession.  I do this with some trepidation, since it is possible that there will later be a tenth lesson: that given that it took fifty years for the profession to develop its current understanding of the monetary policy transmission mechanism during the Great Depression, just two years after the Lehmann Brothers bankruptcy is too early to be drawing even preliminary lessons from the Great Recession.  But let me join the crowd and begin doing so.


The ninth:

In a crisis, central bankers (and no doubt other policymakers) will often find themselves implementing policy actions that they never thought they would have to undertake – and these are frequently policy actions that they would prefer not to have to undertake. Hence, some final advice for central bankers :

Never say never