Charles Calomiris suggests that the Fed will probably need to raise rates this year:
Furthermore, because the fall in energy prices is a positive supply shock, nominal GDP growth will not be reduced by the decline in energy prices; indeed, it is likely to accelerate going forward. That means real GDP growth will accelerate alongside nominal GDP growth. From the perspective of forward-looking inflation targeting, the Fed rightly understands that it needs to maintain its plan to begin to remove accommodation this year.
Overall it’s a thoughtful article, but I can’t help thinking that something is missing. First let’s review the difference between inflation and NGDP targeting. If we use the equation of exchange:
You can think of the two regimes as offsetting velocity shocks, but responding differently to supply shocks. Under strict inflation targeting, you shoot for 2% inflation no matter what. Under flexible inflation targeting (such as the Fed’s dual mandate, or NGDP targeting), the Fed lets inflation rise and RGDP fall during a negative supply shock. Calomiris correctly points out that in the near term it might make sense for the Fed to let inflation fall below 2%, and RGDP to accelerate, as long as NGDP is well behaved.
So far so good. So what’s my nagging worry here? My concern is that the Fed doesn’t seem to have the right REGIME in place. So even if they handle the current oil price decline correctly, I’m not confident they will avoid the horrendous mistakes made in 2008-09, in the next recession. To understand those mistakes let’s review three options:
1. Stable inflation
2. Countercyclical inflation (this is what the Congress, Calomiris and I all seem to prefer.)
3. Procyclical inflation
You might be thinking; “Wait a minute, I don’t recall Congress asking for countercyclical inflation.” Not explicitly, but it’s implicit in the dual mandate. Obviously the dual mandate rules out option #1, which ignores jobs. Any loss function that worries about both inflation and jobs, will bias policy toward more stimulus when unemployment is high, and less stimulus when unemployment is low. This means the Fed will face a “trade-off” and will tolerate slightly above target inflation when unemployment is higher than desired, and slightly lower than target inflation when unemployment is low. Inflation should be countercyclical.
Let’s contrast this approach with its exact opposite. Suppose Congress had instructed the Fed to target inflation at 2%, but, “while you are at it, try to be as cruel to the jobless as possible. Create as much jobs market instability as possible, consistent with 2% inflation over time.”
Under that mandate (let’s call it the “cruel mandate”) the Fed would do a tight money policy when unemployment is above target. Yes, they’d miss their inflation target on the low side, but that loss would be offset by the “benefit” that they’d receive from screwing the workers. Under that sadistic policy they’d run a procyclical inflation rate, just the opposite of what they are currently supposed to do.
Now of course this is exactly what the Fed did in 2009, they ran inflation well below target during a period of 10% unemployment. Defenders of the Fed will claim that this was unintentional. I agree. But it was also due to a flawed inflation targeting IT regime, which biases you toward procyclical inflation, especially at the zero bound. And my fear is that that regime still is in place.
Let’s suppose the next 5 years are pretty good, and then we have another recession. If you look at the next 5 years in isolation, the period would be a “boom” in a relative sense. In that case Calomiris is quite right that the Fed should run inflation a bit below target right now. But this policy only makes sense if it is offset by above target inflation during the high unemployment periods before and after the boom. In fact, we did the opposite during 2009-13, and I fear we will again do the opposite in the next recession. I fear that instead of inflation rising in the next recession, (which would make Calomiris’s current recommendation appropriate, the Fed will let inflation fall, which will put us right back at the zero bound, and retrospectively make Calomiris’s proposed policy a mistake.
Robert Lucas emphasized that you need to think in terms of policy regimes, not day-to-day decisions. I don’t care very much whether the Fed raises rates by a quarter point this year. I care a lot whether they successfully make inflation rise during the next recession, or disastrously allow it to fall.
So what will it be; the pre-2008 dual mandate or a continuation of the post-2008 cruel mandate?
BTW, there are several options that could make the cruel mandate outcome less likely. One option is to raise the inflation target to 3% or 4%, to minimize the zero bound problem. A better option is NGDP level targeting, which also reduces the zero bound problem, at a lower inflation rate. Best of all is NGDP futures targeting. No zero bound problem.
HT Ramesh Ponnuru