Mark Carney had this to say in the FT:
Central banks are most effective when they operate with clear and stable objectives. The pursuit of temporarily higher inflation could only work if policy were anchored to a new target, such as nominal gross domestic product – total output at market prices, unadjusted for inflation.
However, the uncertain rewards of such a regime shift must be weighed against the risks of giving up what is arguably the most successful monetary policy idea in history: flexible inflation targeting.
This is wrong. The Bretton Woods system was considerably more successful. Here’s the flaw in Carney’s reasoning. He’s thinking in terms of low and stable inflation as being the goal of monetary policy. But it’s not. There is no plausible macro model where fluctuations in inflation between -2% and 6% directly produce significant welfare losses. The argument was always about aggregate demand. Economists saw inflation instability leading to output instability (the famous expectations-augmented Phillips Curve) and decided stable inflation was the best way to stabilize AD, and hence output. But by that criterion inflation targeting has been a disaster, as it lead to the greatest collapse in AD since the Great Depression, in both the US and Europe. Admittedly Carney is a governor of the Bank of Canada, and Canada has done considerably better than the US and Europe during the current crisis. But Carney’s piece isn’t just about Canada, he’s defending inflation targeting as the standard policy regime for developed economies.
I don’t favor a return to Bretton Woods, as we can do much better than either inflation targeting or fixed exchange rates. Here’s Samuel Brittan, also in the FT:
At the other end of the spectrum some financial market types have taken fright at the trillions of dollars created by central banks for firewalls and in “quantitative easing”. I would not dismiss these fears out of hand. It is easy to imagine a long period of stagnation or recession followed by a breakout into rapid inflation.
Yet there is a way of sustaining an expansionary policy while minimising this threat. This is not through any financial market gimmick but by a different way of thinking. Long-time readers will not be surprised to learn that I have in mind something usually called a nominal GDP objective. One of the greatest obstacles is that its name is so off-putting. I seem to remember a former chancellor, Nigel Lawson, saying that it lacked sex appeal.
Yet the basic idea could hardly be simpler. The growth figures that dominate the headlines are of “real” gross domestic product, which means they are corrected for inflation. With nominal GDP they are uncorrected. The idea of targeting nominal GDP is to leave room for real growth, but damp any inflationary take-off.
That’s right. There is an alternative to our current nightmare.
I hope to finish my grading today, and will then address the backlog of comments.
HT: Bruce Bartlett and Nicolas Goetzmann