Ryan Avent on monetary policy
Ryan Avent has an outstanding essay on monetary policy that traces out how monetary policy ended up on the wrong path:
But the total amount of spending in the economy is nothing more and nothing less than aggregate demand. If demand were higher, people would have spent more. If it were lower, less. Monetary policy, at all times, controls demand. In the short run, higher demand will generate an uncertain mix of changes in the economy””some price and wage increases but also some real output increases””so that higher inflation is, at all times, likely to accompany higher demand. There is no pure, sterile stimulus that the Fed can deliver that will bring higher real growth without higher prices, as Bernanke now claims he would like to do.
. . .
Central banks should focus their efforts on measures of demand — nominal GDP, nominal income, nominal spending””rather than measures of inflation. If nominal GDP is at a level that’s inconsistent with full employment, demand is too low and the central bank should do more. That might take inflation above some arbitrary level, and that’s totally fine. It won’t stay above that arbitrary level and accelerate unless the central bank keeps raising demand indefinitely. This is not to say that there are no costs to having 4% inflation for a year rather than 2%. There are surely some efficiency costs to changes in relative prices. But if the alternative is a trillion dollar output gap and 6 million unnecessarily unemployed workers, that’s probably a pretty good trade-off to make.
We learned a hugely important lesson from the Depression””that central banks could influence the economy and prevent demand-side macroeconomic disasters. But we took a wrong turn in thinking that the way they did this was by moderating inflation. It was as if we discovered a magical sword in the woods and then went about confronting enemies by whacking them with the sheath.
Read the whole thing.
I was perplexed by a recent Tyler Cowen post:
3. Price inflation and stock returns (pdf), and here, and here, and most recently here; “There is a consistent lack of positive relation between stock returns and inflation in most of the countries.” I am urging a) a bit of caution, and b) engagement with the literature on this topic. I do favor a more expansionary monetary policy, but I see the balance of evidence as different from how it is frequently portrayed in the blogosphere.
The study he cites looks at data from 1966-2009. Market monetarists have argued that higher inflation did not help either the economy or the stock market prior to 2008. After 2008 stock prices became strongly correlated with inflation expectations from the TIPS markets. (David Glasner has documented this pattern, which is actually pretty obvious to anyone who followed the TIPS spreads and equity prices in recent years.)
Stocks and TIPS spreads became highly correlated after 2008 because the economy’s main problem was too little NGDP, and higher inflation expectations were correlated with higher NGDP growth expectations. Prior to 2008 higher inflation merely pushed up real tax rates on capital. Maybe I misread Tyler’s post, but he seems to imply that this study was somehow in conflict with the argument for monetary stimulus, when in fact it supports our argument. Indeed the pattern found by David Glasner (and other researchers) may be the single most powerful piece of evidence in favor of our position.
PS. Robert Hetzel sent me this interesting article by Dylan Matthews in the Washington Post:
Alternatively, the Fed could have targeted nominal GDP “” that is, the real size of the economy multiplied by the rate of inflation. This idea, made famous by Bentley University’s Scott Sumner and embraced by the likes of former White House chief economist Christina Romer, would have the Fed allow inflation to rise during an economic downturn, and tamp back on growth if inflation is getting too high during an upswing. Though Bank of Israel governor Stanley Fischer “” coincidentally, Ben Bernanke’s dissertation adviser “” hasn’t explicitly embraced this idea, economic wunderkind Evan Soltas has mustered some evidence that Fischer has been following this policy. Israel let inflation rise when the recession hit by the same amount as economic growth fell, and as a consequence, the economy quickly rebounded:
Source: Evan Soltas.
In the United States, by contrast, inflation stayed constant while both real and nominal GDP fell considerably:
Of course, the United States and Israel are very different countries and what worked for them may not have worked here. But the evidence suggests they were doing something right.