As you know, I have relentlessly argued that the Fed made a huge mistake in mid-2008 by not targeting NGDP at about a 5% growth trajectory, level targeting. If they had done so, NGDP almost certainly would not have fallen last year, and the recession would have been far milder. But 5% NGDP growth, which implies about 2% trend inflation, almost certainly is not the optimal monetary target in the long run. I picked it because the Fed had been implicitly targeting NGDP at around 5% for several decades, and since all sorts of wage and debt contracts in 2008 had been negotiated under the reasonable assumption that we would continue to have roughly 5% NGDP growth, it didn’t seem like a good idea to enact a highly deflationary policy in the midst of a financial crisis. But I’m not running the Fed.
In fact, the optimal inflation rate is probably either lower or higher than 2%. If we were to assume the Fed adopted NGDP forecast targeting, level targeting, then we would not have to worry about “liquidity traps,” i.e. the zero-rate bound on conventional monetary policy. In that case we’d be better off with a lower inflation rate. Neither Bill Woolsey or George Selgin advocate inflation targeting; their proposals are somewhat closer to my NGDP idea, but Woolsey’s plan would likely lead to near-zero inflation in the long run, and Selgin’s plan would probably lead to slight deflation on average. These are sensible ideas if we have sound monetary policy, as inflation is a tax on capital, and lowers the rate of economic growth.
On the other hand if we don’t have a sensible monetary policy regime, then low inflation makes an economy more susceptible to bumping against the zero-rate bound. Nick Rowe compares the problem to balancing a tall pole in one hand. If you want to make the top of the pole go left, you move your hand to the right. If the Fed wants inflation to rise, it lowers the fed funds rate. But suppose while balancing the pole you bump up against a wall, then you can’t move your hand further to the right, and thus can’t move the top of the pole to the left. That’s a liquidity trap. Of course both Nick and I realize that you aren’t really stuck, you can climb a ladder and directly pull the top of the pole in whatever direction you like. But many central bankers are afraid of heights.
So let’s suppose you have a central bank full of meek, timid souls. What sort of inflation rate is optimal? I’ve mentioned that you’d probably be better off with an inflation rate even higher than 2%. But I never really developed the idea, as I didn’t want people to associate my 5% NGDP rule with a policy of printing money to get out from under our debt burden. I am not an “inflationist” or a monetary policy ”dove.” Still, I should have done a post and let the chips fall where they would. Fortunately, Andy Harless has done so, and much more elegantly than I could have.
In the 1980s we brought inflation down from double-digits to about 4%. Should we have declared victory and stayed at that level? In retrospect, we probably should have. We did get inflation down to about 3% in the 1990s, and only 1.8% in terms of the GDP deflator from mid-2000 to mid-2008. At the time I thought this was good, because it lowers the real tax rate on capital. But in retrospect it was a big mistake, as the cost of the liquidity trap we stumbled into in late 2008 will vastly exceed the gains from 1% or 2% lower inflation. Indeed one of the costs will be a massive increase in our national debt, which will almost certainly lead to much higher tax rates on saving and investment.
Interestingly, I know of only one country that stayed away from the ever lower inflation obsession of the major central banks. The Bank of Australia. Australia had about 4% inflation in their GDP deflator and 7.4% NGDP growth between 2000:2 and 2008:2. With a much higher inflation and NGDP trend rate going into the crisis, they we able to avoid the zero interest rate bound. And by the way, for those who think nominal shocks don’t explain real events like the recent recession, Australia was the only major developed economy to avoid a recession last year. Indeed they haven’t had one since 1991. They are called ‘the lucky country,” but I have argued that their culture lacks our puritanical obsession with inflation. Perhaps each member of our FOMC should drink a 6-pack of Fosters before their policy meetings.
PS. Matt Yglesias quoted Harless and then asked:
I would like to see more commentary on this matter from smart and informed people before I say I’m taking this account to the bank. But it seems to me to be an obvious enough question to ask especially since there are a variety of other reasons to think that something like a 3-4 percent inflation rate would be more desirable than a 2 percent inflation rate.
I don’t know if I am smart, but I think I am reasonably well-informed, so I’ll take a stab at the question. If we ever get to NGDP targeting, a lower than 2% rate would be optimal. Under our current far from perfect system, I’d say Yglesias and Harless are about right.
PPS. Economic development is a much more important issue than monetary policy. About the time he switched from money to development, Robert Lucas said that “once you start thinking about economic growth, it is hard to think about anything else.” I sometimes feel guilty talking about these comparatively minor issues at a time when there is such a horrible tragedy in Haiti. But I really don’t know enough about that issue to provide any useful ideas, and other bloggers like Tyler Cowen are covering the topic far better than I could.