My posts are too long, so I’ll break this up into two parts.
Consider the following policy options. Assume a standard AS/AD model with some wage and price stickiness.
1. An amoral monetary policy:
Let’s suppose central bankers cared only about keeping inflation at a steady rate of 2%/year. They know that monetary policy also affects employment fluctuations, but they don’t care about workers. Let’s call that policy “amoral.”
2. An empathetic monetary policy:
Now let’s assume the central bank still prefers stable inflation of about 2%, but also wishes to avoid suboptimal employment fluctuations. What should they do if unemployment rises to 10%, and many workers lose jobs because wages and prices are not completely flexible? In that case the central bank must trade-off two goals; stable inflation and stable employment. It will probably be optimal to allow slightly higher than 2% inflation, if the policy that does that (monetary expansion) also reduces unemployment in the short run. So they might allow 3% percent inflation to reduce unemployment to 8%.
What if employment is too low? Suppose NGDP has risen fast and companies are forcing workers on long term contracts to work lots of overtime. They miss deer hunting season. They are grouchy to their wives. But they have no choice. The Fed can reduce inflation slightly below 2% with tight money, and this will tend to push employment levels down closer to their optimal point. That would be the amount of work that would occur if labor contracts had been negotiated with full knowledge of current levels of AD.
You may have noticed that this is roughly what NGDP targeting does, although there are many other versions of this general idea.
3. A sadistic monetary policy:
Now suppose central bankers get pleasure from the suffering of workers. They enjoy the thought of workers losing their jobs. If unemployment hits 10%, what is the optimal policy response from the central banker’s perspective? Recall that, other things equal, they prefer a steady inflation rate of 2%. If unemployment hits 10%, they will want to make workers even a bit worse off with tight money. This will result in lower than 2% inflation. Perhaps 1%. The lower inflation is bad from the central bank’s perspective, because they prefer a steady 2% rate. But they are willing to pay the price of lower than desired inflation in order to get more unemployment–as they enjoy the suffering of workers.
This is just the standard economics of a trade-off between two goods; price stability and worker suffering. A very simple model.
At this point the more astute readers may assume I am about to accuse the Fed of being a bunch of sadists. Actually no. Indeed I find the thought rather preposterous. No matter how much you might dislike central bankers, they are not sadists. I don’t even think they are amoral.
In addition, although the sadistic scenario seems to apply to the current policy situation, it actually fits almost every recession in my lifetime, in the US and many other industrial countries. I could tell the same story about the BOJ or the ECB.
Instead, I’d like to argue that central bankers are a bunch of well-meaning (or at worst amoral) people who act like sadists because they have the wrong model in their heads. They think that it is “natural” for inflation to fall during periods of high unemployment. And we know that ‘natural’ means good. After all, natural foods are good for you, aren’t they? Why do they think low inflation is natural in a weak economy? Because it almost always happens. When it doesn’t happen, e.g. 1974, the event is viewed as bizarre.
Here’s the problem with their reasoning. The reason inflation almost always falls during a weak economy is because the cause of a weak economy is almost always, at least partly, a reduction in M*V. When M*V growth falls sharply, so does both inflation and real growth. (I emphasize sharply, because this is less true of mild declines.)
This is why central bankers can sleep at night knowing that inflation is likely to be only 1% over the next year or two, they see that as a natural occurrence during a severe recession.
But I can’t sleep at night. I see insufficient NGDP as the cause of the problem. To me, a steady 5% growth in NGDP is “natural.” If we had that, then inflation would rise when unemployment was high and output was low. During an oil shock you might get a year of 1% real growth and 4% inflation. During a tech boom you might get two years of 4% real growth and 1% inflation. In the long run you’d get 3% real growth and 2% inflation. When unemployment was high (oil shock) the Fed would push inflation higher than 2%. That’s what’s normal for me. What the Fed considers normal, I consider sadistic. Not just this Fed, but earlier Fed’s, and foreign central banks as well. If I knew there was 10% unemployment, I couldn’t sleep at night knowing the markets were predicting only 1% inflation, whereas the target was 2%. I’d keep asking myself; “Why not do more stimulus? We’d improve both the unemployment and inflation situations at the same time.”
At this point you’re saying to yourself; “But all this is because you are assuming sticky wages and prices are the problem, suppose it’s some sort of structural problems in the economy. That changes everything.” Actually, it doesn’t change anything, but that’s for the next post.