Well this is the post we’ve all been waiting for, isn’t it? Ben Bernanke has a post discussing options for monetary reform. As you’d expect, it’s a really well thought out post—first rate. And as you’d expect, I am still able to find a few points where I disagree. But let’s start with the good stuff:
Of course, no policy framework is without drawbacks, as attested by the difficulties the FOMC has faced in dealing with the zero lower bound on interest rates. If the Committee were to contemplate changing its framework, there are two directions it might consider.
He’s open to alternatives, and recognizes that policy has been less effective since 2008. The first alternative is a Taylor-like instrument rule, which Bernanke finds useful but a bit too rigid to rely on completely. Ben shows he’s a natural blogger by providing a long quote explaining why policymakers cannot rely too rigidly on a mechanical rule, before telling us:
As some will have guessed, the quote is from John Taylor’s classic 1993 paper introducing the Taylor rule, “Discretion versus Policy Rules in Practice” (pp. 196-7).
A little bit of teasing from the former Fed chair to (perhaps) the next Fed chair if the GOP retakes the White House. Then the second alternative:
The second possible direction of change for the monetary policy framework would be to keep the targets-based approach that I favor, but to change the target. Suggestions that have been made include raising the inflation target, targeting the price level, or targeting some function of nominal GDP. Some of these approaches have the advantage of helping deal with the zero-lower-bound problem, at least in principle.
My colleagues at the Fed and I spent a good deal of time during the period after the financial crisis considering these and other alternatives, and I think I am familiar with the relevant theoretical arguments.
I’m sure that’s right, and I’m certain there is nothing theoretical that I could have added that would have carried much weight at the Fed. They’d be better off talking to people like Michael Woodford. Nonetheless, later I’ll argue that the Fed was not fully aware of the political implications of these alternatives.
Although we did not adopt one of these alternatives, I will say that I don’t see anything magical about targeting two percent inflation. My advocacy of inflation targets as an academic and Fed governor was based much more on the transparency and communication advantages of the approach and not as much on the specific choice of target. Continued research on alternative intermediate targets for monetary policy would certainly be worthwhile.
One of Bernanke’s good qualities is that he’s open-minded. He obviously sees that given what’s happened since 2008, in retrospect a slightly different approach might have been better. But of course we can’t rewrite history, and there are credibility issues that constrain policy, as they should. The italicized phrase may surprise some readers who don’t play close attention. I’ve always argued that it would have been quite difficult for the Fed to abandon its 2% inflation target right after formally adopting it in 2012. A central bank that is so cavalier with previous promises would not be trusted any more than the Argentine central bank.
Finally we get to the key three paragraphs:
That said, I want to raise a few practical concerns about the feasibility of changing the FOMC’s target, at least in the near term. First, whatever its strengths and weaknesses, the current policy framework, with its two explicit targets and balanced approach, has the advantage of being closely and transparently connected to the Fed’s mandate from Congress to promote price stability and maximum employment. It may be that having the Fed target other variables could lead to better results, but the linkages are complex and indirect, and there would be times when the pursuit of an alternative intermediate target might appear inconsistent with the mandate. For example, any of the leading alternative approaches could involve the Fed aiming for a relatively high inflation rate at times. Explaining the consistency of that with the statutory objective of price stability would be a communications challenge, and concerns about the public or congressional reaction would reduce the credibility of the FOMC’s commitment to the alternative target.
Second, proponents of alternative targets have to accept the fact that, for better or worse, we are not starting with a blank slate. For several decades now, the Fed and other central banks have worked to anchor inflation expectations in the vicinity of 2 percent and to explain the associated policy approach. A change in target would face the hurdles of re-anchoring expectations and re-establishing long-term credibility, even though the very fact that the target is being changed could sow some doubts. At a minimum, Congress would have to be consulted and broad buy-in would have to be achieved.
Finally, a principal motivation that proponents offer for changing the monetary policy target is to deal more effectively with the zero lower bound on interest rates. But economically, it would be preferable to have more proactive fiscal policies and a more balanced monetary-fiscal mix when interest rates are close to zero. Greater reliance on fiscal policy would probably give better results, and would certainly be easier to explain, than changing the target for monetary policy. I think though that the probability of getting Congress to accept larger automatic stabilizers and the probability of their endorsing an alternative intermediate target for monetary policy are equally low.
There’s much that can be said here, and I’m going to consider the question of Congressional authorization in another post, over at Econlog. But let me just say here that I think he’s wrong about price level and NGDP targeting, I don’t think they would require Congressional authorization. A 4% inflation target perhaps would.
Obviously I don’t think fiscal policy would be better than monetary reform, but it’s a moot point as we both agree that Congress is not about to start using fiscal policy to stabilize the economy at the zero bound. Nor are the Europeans or the Japanese. Indeed the Japanese sharply tightened fiscal policy in 2014 (and unemployment fell). So with fiscal policy off the table we need to improve monetary policy to make it more effective.
Reading between the lines, and based on what I’ve read from various insider sources, Bernanke may have the following concerns:
1. Congress would not like a 4% inflation target.
2. The Fed establishment hates (price or NGDP) level targeting. It puts them right in the spotlight, with “ownership” for adverse moves in the nominal economy. They’d rather be one of many factors making our economy work better.
Here are a few areas where I disagree with Bernanke’s pessimism. Let’s start with communication. It’s often claimed that it’s easier to communicate an inflation target than a NGDP target. “The public understands inflation.” No they don’t!!! They don’t have a clue as to what inflation means. Most of my students were far above average, and yet when I would ask them the following question (as economics major seniors), 90% would get it wrong:
If all prices rise 10% and all wages and salaries also rise 10%, has the cost of living actually risen?
Most say no, whereas the correct answer is that the cost of living rose 10%. Bernanke discovered this in 2010 when core inflation fell to 0.6% and the Fed announced it was going to try to raise the cost of living for Americans, to help the economy. Talk radio went nuts, and Bernanke ran into a firestorm of criticism. It sounds “bad.” The Fed may correctly view 2% as a symmetric target, where misses in either direction are bad, but the public sees it more like the ECB, the lower the inflation the better. That’s because the public thinks their own nominal income is unrelated to changes in the cost of living, whereas the Fed believes that monetary stimulus will boost RGDP, and this causes the average American’s nominal income to rise even more than inflation rises. Inflation targeting is a communication nightmare.
Second, Bernanke seems to overlook the fact that even with its current dual mandate there are times where the Fed must pursue an inflation rate higher than 2%. Indeed if it were not true, if they always focused like a laser on 2% inflation, then they’d have a single mandate, and their policy would be indistinguishable from a central bank with a single mandate. In fact, when there is a severe adverse supply shock, such as an oil embargo, the Fed does aim for above 2% inflation. In this respect, NGDP (growth rate) targeting is very similar to current Fed policy. As far as price level targeting, the Fed could easily argue that aiming for a long run 2%/year rise in the price level is more consistent with their Congressional mandate, as it provides more long price level predictability that inflation targeting (where the price level has a random walk element.)
I’ve already indicated that the “blank slate” argument is a genuine concern. But I also have argued that there are creative ways of addressing this issue. A likely compromise would involve the Fed setting intermediate NGDP target paths every 5 years, where the target growth rate was the Fed’s estimate of trend RGDP growth, plus 2% inflation. That would keep inflation close to 2% in the long run, while gaining some of the advantage of NGDPLT over the business cycle. For those who worry that inflation would vary somewhat, recall that under current policy inflation reached almost 5% in mid-2008, and then fell into negative territory over the next year. That doesn’t seem very stable to me.
As far as communication, the Fed should continue to communicate to the public that it has a 2% inflation goal (if that’s indeed what Congress wants) but communicate to the markets that it has an intermediate NGDP target that it thinks is most consistent with its combined inflation/employment goals.
And finally, I think some of the concern that NGDPLT might be inflationary was due to the fact that the issue happened to gain traction at a very unusual point in US history, where trend RGDP growth was falling from 3% (over more than a century) to 2% or even slightly less. But that’s likely to be a fairly rare occurrence. God help us if the rate keeps falling to zero. In that case monetary policy will be the least of our concerns. We’ll be broke.
HT, Patrick Sullivan, Ken Duda, Britonomist