John Taylor has written a number of articles that are critical of the Fed’s current discretionary regime. It’s difficult to know what the Fed is trying to achieve, and how they intend to get there. This creates uncertainty in the marketplace, and greater macroeconomic
instability stability. Naturally Taylor focuses on the need for something like the Taylor Rule. In contrast, I’ve advocated NGDPLT, with the same goal—reducing discretion and making the Fed more accountable.
In this post I plan to talk about a policy that I don’t favor, in the sense that it’s not my first choice. On the other hand it’s a policy I do favor, in the sense that I’d vastly prefer it to current Fed policy. I’m hoping that if Taylor Rule supporters read this post they’ll have a better idea as to where I’m coming from.
My proposed rule is CPCELT, that’s “core PCE level targeting.” Why this target?
I see two big sources of discretion and ambiguity in the current target, which is PCE inflation targeting:
1. One problem is supply shocks. It’s widely known that pragmatic central banks may want to allow some price level variation when there is a supply shock. For instance, if oil prices suddenly change, then keeping overall inflation on target would require moving “all other prices” in the opposite direction. But those other prices are often stickier than oil prices, and trying to move them suddenly can create business cycles. Thus central banks often allow some inflation variation when there are supply shocks, especially to food and energy, and in some cases they point to core inflation as being more meaningful, at least in the short run.
And yet central banks also insist that they are targeting headline inflation in the long run. This is supposed to reassure the public, because the public cares about headline inflation. There are two problems with catering to public opinion in this case. First you are pandering to ignorance. Even if the Fed prevents supply shocks from increasing the price level in the long run, they will not be able to prevent the associated loss of real income, which is why the public cares about inflation in the first place. Economists know that the public misunderstands the effect of inflation on living standards, but we pander to that ignorance when we insist we’ll stabilize headline inflation in the long run. The second problem is that the public thinks of inflation in terms of the CPI, but the Fed targets the PCE. So we aren’t really targeting what the public thinks of as “inflation,” even with a headline PCE inflation target. PCE inflation runs about 0.35% below CPI inflation.
So I propose the Fed target what they actually care about, core PCE inflation. That increases accountability, as the Fed can no longer point to temporary oil and food price changes as excuses.
2. The second problem is growth rate targeting. Under growth rate targeting we have no idea where the price level will be in 10 or 20 years, making long term planning more difficult. Suppose prices fall, as in 2009. Is the Fed trying to make up some of that fall, or shoot for 2% inflation from that point forward? It’s hard to say. Perhaps errors are a sort of random walk, and the price level gradually drifts further and further from that trend line. Even worse, a central bank that pays lip service to inflation targeting, but doesn’t seriously try to get there (say the Pre-Abe BOJ) can let the price level gradually drift lower for 20 years, each year claiming they just missed by 1% or so. At the other extreme, the dovish Bank of England can consistently run slightly above target.
Level targeting is a way of forcing central banks to do what they claim they are trying to do. Under level targeting you always have a precise point estimate of where PCE core price level is supposed to be in 2 or 3 or 5 years. It’s a way of holding central banks accountable. You still allow some variation in the very short run, assuming there is the dual mandate. But they can no longer act like magicians, directing your attention somewhere else when they persistently fail to hit their goals. “Look at oil.” “Look at unemployment.” “Don’t worry, we’ll get there eventually, despite the TIPS market saying we won’t.” Those excuses won’t work; they’ll eventually be exposed if they persistently miss.
If there is to be a dual target (which is something I don’t like, and why I favor NGDPLT instead) then central banks must also be held accountable on the unemployment front. In recent years, inflation has run below target when unemployment is high, and vice versa. The Fed should be instructed to do the opposite, and its effectiveness should be judged on that basis. They should have to explain to Congress why inflation is below target when unemployment is high, as that’s even worse that a rigid single mandate for inflation.
To summarize, with CPCELT central banks will no longer be able to offer the following excuses:
1. We missed because of temporary factors like food and energy prices.
2. We keep missing by 1/2% on the low or high side, year after year, but in the future we promise to do better.
But there are other advantages as well. When prices fall, as in 2009, inflation expectations automatically rise (they actually fell under the current regime) and this reduces real interest rates, boosting the economy. During the housing boom the market would have understood that core inflation was overshooting, and that awareness would have led to more bearish expectations—reducing speculation. In addition, some macro models suggest that you want to target the stickiest price, which might be wages. Core inflation is more closely correlated with wage inflation than is headline inflation.
Everyone knows that a NGDP target would have called for a more expansionary monetary policy in recent years. But the same is true for core PCE. Core PCE inflation averaged 2.03% between December 1990 and December 2007, then the inflation rate fell to 1.4% between December 2007 and December 2014. Under the dual mandate you’d prefer slightly lower inflation during the booming 1990-2007 period, and slightly above 2% inflation during the depressed 2007-14 period. Even under a single inflation mandate this sort of variation is unacceptable, as it creates macroeconomic instability. Under a dual mandate it’s even more unacceptable.
To conclude, my critique of the Fed goes far beyond the fact that they are targeting inflation and I’d prefer NGDP. Even under inflation/price level targeting there could be vast improvements, which would reduce discretion, increase accountability, and make the economy more stable.
Of course there’d still have to be a conversation about the instrument rules needed to hit this target. But I firmly believe this sort of regime would vastly reduce the discretion/accountability/ambiguity problems that John Taylor worries about, even before we moved on to the policy instrument issue.
PS. This post is a response to commenter SG.