Many New Keynesians point out that there is a class of flexible inflation targeting rules that perform better (from a welfare perspective) than NGDP targeting.  This is true.  In a previous post I pointed out that I agreed with Woodford’s claim that NGDPLT is not in general the “optimal” policy rule.  After reading some comments I realize that I need to amend that post.  That’s because I don’t accept the validity of the New Keynesian models that show flexible inflation targeting is superior to NGDPLT, and should not have implied that I did.  I view a completely different rule—nominal wage targeting—as being the theoretical ideal.

[My first line was poorly worded–I meant “a class of models with flexible inflation targeting rules that perform better . . .]

I just noticed that George Selgin left a comment that nicely characterizes my objection to new Keynesian monetary models:

I think that Scott and others are granting far too easily the “nominal GDP targeting isn’t optimal but it’s a good pragmatic solution” argument. Having looked closely at Woodford’s work, and at other work in the same vein, I find that somewhere there is always a loss function, not always implicit, that treats fluctuations in P as “bad,” but without supplying any compelling justification for doing so. Instead, there’s some rather transparent hand-waving that amounts to saying that this treatment itself is “not optimal but pragmatically justified” or something like that. (The same, by the way, can be said of Wicksell’s own argument for treating zero inflation as optimal-that is, for equating a policy that achieved it with one that kept interest rates at their “natural” levels. In fact his argument here goes through only if productivity growth is constant, which of course it usually isn’t.)

Of course, it’s almost certainly true that no particular NGDP (or nominal income) target is “optimal.” But it doesn’t follow that it isn’t at least as optimal as the usual alternatives. And there are now a number of studies, DSGE and otherwise, supporting this conclusion.

I agree with George 100%.  I’ve often argued that the supposed “welfare costs of inflation” are better thought of as the welfare costs of volatile or excessive NGDP growth.  This also has implications for the supposed “lack of models” in the market monetarist camp.  I believe that I have provided models, but that other economists don’t recognize them because they don’t know what a model is.  They think (wrongly) that a model is a bunch of equations.  Don’t get me wrong; equations can be useful.  I once published a model with equations showing the optimality of wage targeting.  Another time I did the same for NGDP futures targeting.  But in all truthfulness the equations in those papers merely demonstrated what was already intuitively obvious given the model’s assumptions.

Here’s what a lot of economists don’t realize.  We aren’t yet at the stage where mathematical models can show which policy is best.  We simply don’t know enough about the welfare costs of inflation.  Obviously if you think the CPI is a good proxy for the welfare costs of inflation, then inflation is likely to play a role in your optimal policy rule.  And if you think (as George and I do) that NGDP is a better proxy for the welfare costs of inflation then NGDP may play a role in your policy rule.  That’s just common sense.

In the 1970s Milton Friedman argued that macroeconomics had advanced beyond Hume in one respect only—we now know how to deal with the first derivative of nominal changes.  In the 1920s economists debated macro issues using words, not equations.  There’s something to be said for going back to that approach.

George Selgin has a characteristically thoughtful column warning against excessive gloating by market monetarists. He points out that the new Fed policy is far from optimal (and far from the recommendation of us market monetarists) and that there’s a danger of it generating another cycle of boom and bust–just like the low rate policy of 2003-04.

My views on monetary policy aren’t actually all that different from George’s, but I have a somewhat different view of the overall picture.  I’ll try to break it down into several separate issues:

1.  When I started blogging in 2009 there was almost no one who believed the Fed could do more, and should do more.  I believe that by 2010 we (market monetarists) where able to convince many in the blogosphere that the Fed could and should do more.  Here’s Ryan Avent in 2010:

I SEE that Scott Sumner is taking a victory lap of sorts””not unearned””over the fact that views of monetary policy have come full circle since the years before the crisis. Once upon a time, the Fed was viewed as having near-absolute power over the path of the economy. Then crisis struck and many argued that the Fed had run out of ammunition and fiscal policy was required. Eventually people began arguing that the Fed could do more and should do more, thanks largely to the efforts of Mr Sumner himself.

Ouch!  I guess I do gloat too much.  Sorry.

But I do take great satisfaction that there has been progress on that front.  I believe that George Selgin agrees with me that the Fed should have and could have done more in 2009, although he is less convinced about the need for monetary stimulus under current conditions.  I’ve also tried to convince the blogosphere of other ideas, such as “targeting the forecast” and that there is no “wait and see.”  I think it’s fair to say I’ve completely failed (thus far) to make headway in that direction.  Roughly 100% of the blogosphere has reacted to QE3 by discussing likely future outcomes for AD/NGDP, as if in the future we’ll learn more than we already know.  I view that as akin to astrology.  I’ve argued that the lack of a government subsidized RGDP and NGDP futures market represents gross negligence on the part of the Fed, and more broadly the economics profession, which has not demanded that such a market be created and subsidized.  It would be as if astrologers opposed Federally funded studies to see whether people with certain birth “signs” had certain personalities.  Oh wait . . . the astrologers do oppose those studies.

Despite those failures, I can’t help but be pleased that the market monetarists have been successful in convincing many pundits (perhaps including the Fed) that monetary policy can and should do more when NGDP growth has been the slowest since the Herbert Hoover administration.  At the same time, I’d like to emphasize that most of the “gloating” has been done by non-market monetarists.  Numerous press outlets have basically said; “The Fed is doing market monetarist policies, and it’s likely to be highly successful.”  I’ve consistently said they are only doing about 10% of what we advocate, and it’s likely to be only modestly successful in boosting RGDP.  We already know that it’s only been modesty successful in boosting NGDP expectations–that’s not even in doubt.)  In the post that George linked to I emphasized that the Fed still wasn’t doing targeting the forecast, or level targeting, which were two key components of market monetarism.  So most of the gloating has been in the popular press.  I still think money’s too tight.

I have a “glass half full” personality, so I tend to focus on where progress has been made.  Take the problem of deciding on an optimal policy target.  Some advocate a weighted average of inflation and output gaps.  Some advocate a weighted average of inflation and unemployment gaps.  Market monetarists advocate the sum of inflation and real growth, level targeting.  Unfortunately the Fed did not adopt NGDP targeting.  But in my view the main problem in recent years is not the failure to adopt NGDP targeting, but rather that policy has been far too contractionary using any plausible policy target.  So I can take pleasure in the fact that the Fed is finally waking up to the reality that it needs to do much more to hit its own preferred policy target(s).  And yet I still believe that we’ll have to return and fight another day for NGDP level targeting.  It’s progress, but there is much more work to be done.

George’s most serious charge is that this policy initiative might lead to another boom/bust cycle, such as the recent housing bubble.

Having kept the federal funds rate at 1.75 percent for a year after the economy began to recover in November 2001, the Fed lowered it to 1.25 percent in November 2002, and to 1 percent in June 2003. Then, in August 2003, the FOMC, still unhappy with the sluggish pace of the recovery, and especially with the high unemployment rate, announced that the f.f.r. was “likely” to remain low for an “extended” period of time. Not for the first time, the Fed in its zeal to assist recovery was in fact setting the next boom in motion. And how!

I’m tempted to respond; and how?  Most people, including George Selgin and market monetarists like David Beckworth, believe that an easy money policy during the early 2000s led to an overheated economy in the middle of the decade, and that this was one factor in the crash during the latter part of the decade.  I’m not convinced, or perhaps I should say I doubt the effect was as strong as most people believe.  First of all, I see little evidence that monetary policy was particularly expansionary during the early 2000s.  Some people cite the low rates, but we all know what Milton Friedman said about that.  I agree with Ben Bernanke that NGDP growth is a good indicator of whether money is easy or tight.  Here are the facts about NGDP growth during the previous expansion:

1.  NGDP grew at a slower rate during the 2001-07 expansion than during any other expansion during my lifetime.

2.  NGDP growth modestly exceeded 5% during the peak of the housing boom.

Those facts tell me that while monetary policy might have been a bit too expansionary during the housing boom, the overall level of spending wasn’t particularly excessive, at least by historical standards.  So I reject the implication of “and how!”  George seems to imply that easy money was the key mistake that led to the boom/bust cycle of 2003-09.  I believe there were two key policy failures:

1.  Flawed regulation of banking combined with financial innovation, which pumped up the housing boom.  (Not easy money.)

2.  Tight money in 2008 that turned a mild slowdown involving Hayekian reallocation of capital into a deep “secondary deflation.”

George is particularly concerned about our (my?) silence on the dangers of targeting employment:

But the Fed, in insisting on treating the level of employment as an indicator of whether or not it should cease injecting base money into the economy, departs not only from Market Monetarism but from the broader monetarist lessons that were learned at such great cost during the 1970s. If Market Monetarists don’t start loudly declaring that employment targeting is a really dumb idea, they deserve at very least to get a Cease & Desist letter from counsel representing the estates of Milton Friedman and Anna Schwartz telling them, politely but nonetheless menacingly, that they had better quit infringing the Monetarist trademark.

I have two responses to that charge:

1.  Targeting Employment is a really, really bad idea!!

2.  A target that is a weighted average of inflation and (estimated) employment gaps, is also a somewhat bad idea.  But it’s also almost indistinguishable from targeting a weighted average of inflation and (estimated) output gaps (the Taylor Rule.)  After all, output gaps are estimated partly on the basis of whether or not unemployment looks “high.”  Obviously I believe the Fed is not just targeting employment, they are targeting a weighted average of inflation and employment gaps.  Yes, NGDP targeting is superior, but I’m less concerned about this than George is.  Late in his life Friedman admitted that Taylor Rule-type policies can do about as well as money supply targeting.  The disastrous monetary policies of the 1960s-1970s were not primarily caused by the Fed putting too much weight on employment (though they were), the key problem was that they were ignoring the rise in inflation.  They frequently cut interest rates during periods when inflation was far above 2%.  I don’t see any evidence that the Fed is about to repeat that mistake.  Nor do the markets, which I trust much more than my opinion, or the opinion of any other individual.

Here’s where I think we are:

1.  Market monetarists have a set of ideas that constitute optimal monetary policy.  Others like George Selgin have slightly different views, but accept some of our broad principles.

2.  The Fed is not following the sort of policy that either George or I would favor.

3.  It is often the case that two economists who have almost identical views of the optimal policy rule, have very different views on the best “next step” for a central bank operating under a discretionary regime (like ours.)  I feel that as a public policy pundit I am almost forced to hold my nose and say “well done” when the Fed moves from 4 to 5 on a scale of one to 10.  And I do this knowing that people in the press will misinterpret this “support” as implying I don’t think the next 5 steps (to get to 10) are very important.  I may say they are important, but the message gets lost in all the “gloating.”  So maybe George is right, maybe I need to try harder, so that we don’t rest on our laurels.  I’ve gotten way more laurels in the last week than I deserve, so it shouldn’t be hard for me to pivot to the “glass half empty” message.

PS.  Many NGDPLT advocates favor going back to the pre-2008 trend line.  I’ve recently been arguing for going perhaps only one third of the way back, given how much time has gone by.  So as a born and bred University of Chicago inflation hawk, I’m not unaware of the dangers mentioned by George Selgin.  I want to go to LA, but I’m sitting in the back seat of a car driven by someone who has turned off the GPS.  Despite my annoyance at the driver’s method of navigating, I feel I must do my best to give advice, so that the Fed car doesn’t end up lost in the middle of the Nevada desert.

PPS.  Ryan Avent does a really outstanding job of explaining market monetarism.  But my “no such thing as wait and see” comments are partly directed at his post.  He’s also too generous in his evaluation of my role—but I’m not going to complain.

PPPS.  I don’t like to read other relies before writing my own.  So after I was surprised to find that Lars Christensen’s reply had so many uncanny similarities, such as the “glass half full” metaphor, and the use of bold font in opposing employment targeting.

I’ve often argued that nominal wage targeting is the theoretically optimal monetary policy, but NGDP targeting is a more practical solution to the complex political and economic challenges faced by the Fed.  Michael Woodford seems to agree that other targets are theoretically superior, but NGDP is a good pragmatic second best policy:

The thing about the Jackson Hole talk this year is that probably the most practical version of such a proposal that you can imagine the Fed adopting is an NGDP target. That is a compromise relative to the theoretical ideal. It’s worth asking what you could imagine the Fed actually going for, which is not going to be what, in an ideal world where everyone understood economics perfectly, you would want to do.

Interestingly, several commenters in the previous post thought Woodford’s views on NGDP targeting conflicted with my views.  Not so. They also thought I’d be upset by this part of the Washington Post interview of Woodford:

DM: One big advocate of an NGDP target, on his blog and elsewhere, has been Scott Sumner at Bentley University. Did he influence your thinking on this?

MW: I don’t think it affected me. This theme is one that I had been pushing extensively even before the current crisis, both for reasons that relate to my general views on monetary policy, and the fact that I had been giving talks on responding to the zero lower bound in this general situation. So I already had a well worked out view of that kind. I don’t think it changed my mind about the importance of the particular themes.

Upset?   The Washington Post is one of the elite newspapers in America. And they just asked the world’s leading monetary economist if his views on the Fed were influenced by a professor at a small New England business school.  Yes, I’m heartbroken.

Seriously, five years ago I would have been thrilled to hear a Washington Post reporter ask Woodford if he was influenced by me.  And I still am.

PS.  The blog broke down today—perhaps too much traffic.  I’ll try to move to a more robust platform.

Update:  I also agree with Mark Thoma’s post–NGDP targeting isn’t the optimal policy, but can be defended on pragmatic grounds.

The blogosphere (including my comment sections) is full of commentary on the likely effectiveness of the recent Fed policy initiative.  I’ve already offered my opinion, but I’d like to use some analogies here, as it’s hard to grasp how a policy can be both a big deal, and also way too little.  Imagine a general was sending his troops into battle with bow and arrows, and having no success.  Then he returns the next day with submachine guns.  That would be a pretty effective change in strategy, wouldn’t you say?  But suppose that he still has cruise missiles and tactical nuclear warheads back at the base.  You’d still say the general had brought less than 10% of his firepower into battle.

The Fed hasn’t even come close to pulling out the big guns, which would include:

1.  Level targeting, to make up for shortfalls.

2.  Targeting the forecast; doing very aggressive QE until NGDP expectations are right on target.

On the other hand they seem to have taken at least two important initiatives.  And just as guns are much more powerful that arrows, these Fed tools are much more powerful than previous policies:

1.  Making the size of QE conditional on actual progress on the jobs/inflation front.

2.  Promising to keep policy expansionary for an extended period, even after the economy has recovered.

I speculated that the second policy is a sort of “dog whistle” to the markets—trying to convince them that the Fed would allow slightly above 2% inflation, without formally stating that goal (for fear of setting off the Tea Party.)  Baby steps toward level targeting.  Obviously that’s a tricky maneuver, and I have no idea if it will work.  Bernanke was asked how the Fed would react to above 2% inflation, and indicated that they would bring it down gradually, in a way consistent with their high employment mandate.  They aren’t aiming for high inflation, but they won’t get overly excited if it exceeds 2% for a modest period of time.  Sort of like when the government said they weren’t trying to assassinate Saddam, but wouldn’t be overly concerned if he happened to die in a bombing raid.

Ryan Avent suggested that this policy is a test of the ideas that market monetarists have been promoting.  I agree.  Where I’d differ is that in my view the results are already in on the NGDP front.  The policy succeeded in raising NGDP expectations, but failed to raise them enough to make a dramatic impact on the business cycle.  (I’d guess 0.3% to 0.5% as a ballpark figure for the boost to NGDP expectations.)

There’s another aspect to market monetarism, the claim that more NGDP would lead to more RGDP.  Although we have pretty good proxies for NGDP expectations, I don’t think our RGDP expectations proxies are nearly as good.

[Which is a disgrace.  If we had both types of futures markets, both the MMTers and John Cochrane’s macro views would be refuted within 10 minutes of the Fed announcement.]

So we’ll have to wait on that one.  If NGDP does accelerate sharply (which I don’t expect), and if all the increase comes in the former of higher prices, then I will have been wrong in claiming it’s mostly a demand-side problem.  Oddly, I actually consider that failure much more likely than finding out that the Fed can’t boost NGDP (which I consider extremely unlikely.)  And yet I think most policy pundits would regard the failure to boost AD, or NGDP, as being the more likely “failure.” For some reason there are lots of economists who don’t think the Fed can boost AD (NGDP) and yet also think that if they succeeded it would almost certainly boost RGDP.  I.e. there are still lots of old-style Keynesians.

I have no fear at all of the policy “failing” in the direction of high inflation. It won’t happen.

PS.  I knew I shouldn’t try to list names in the previous several posts.  I forgot David Eagle, who has worked for many years on NGDP targeting.  And people like Doug Irwin, Niklas Blanchard, Kantoos, and many others.  And of course there’s Paul Krugman, who’s 1998 paper started the ball rolling on the expectations approach to the zero rate trap.

PPS.  The Washington Post mentioned my views on QE3.

PPPS.  I was asked whether the new Fed policy will enable Obama’s big spending plans for his second term.  I doubt it.  The policy initiative is too small to decisively impact growth or the deficit, but large enough to take away support for further fiscal stimulus.  Obama will be forced to adopt Simpson/Bowles-style austerity during his second term.  There’s no longer any point in even wasting keystrokes on Mitt’s plans.  He’s done—put a fork in him.

PPPPS.  I was brought back to Earth after fantasies of saving the world economy yesterday, as I revised a NGDP targeting paper for the Mercatus Institute.  There were so many grammatical (and content) suggestions from George Selgin and the other referees that I had to virtually re-write the paper.  Only by putting them side-by-side can I see just how appalling my writing style really is.  George speaks extemporaneously better than I can write.  The good news is that it will probably be my best paper, but I really should make the referees my co-authors.

Seriously, I’m flattered by all the press coverage, but I’ve succeeded in going from being underrated to overrated.  Still, I’m very appreciative of the coverage in The Atlantic and BusinessInsider.

I’d like to point out that this has been a group effort by all of the market monetarists.  Woodford, Krugman, and Jan Hatzius of Goldman Sachs all mentioned David Beckworth.  I’m not trying to engage in false modesty, I presume some of my posts were fairly persuasive, or maybe I’m just a louder voice.  But I lack the technical skills of people like Beckworth and Josh Hendrickson.  Nick Rowe knows much more theory than I do, and is a more creative thinker.  David Glasner and Bill Woolsey know more economic history than I do.  Marcus Nunes and Lars Christensen work harder than I do.  So it’s a real group effort, and I think we complement each other well.  Then there’s Robert Hetzel, who is at the Fed itself, but whose new book on Fed policy is the single most influential market monetarist research in recent years, at least within the profession.  Indeed once you start naming names it’s hard to know where to stop.  George Selgin isn’t in the market monetarist camp, but first developed some of the pro-NGDP arguments used by market monetarists.  He’s also given me good advice on research.  All the George Mason bloggers have been an inspiration.  In late 2008 a student named Tianning Yu gave me the idea for doing a blog.  And of course the many commenters have been a huge help.  Being forced to defend my position against strong arguments has made me sharpen my message, and once in a while it’s led me to change my views.

In case you missed the announcement, before I went to China I decided I wouldn’t respond to comments this fall.  I am teaching an extra class, and have lots of other activities planned.  I still read the comments. Inevitably I do answer a few, but don’t be offended if I don’t get to yours.  I can announce that the Independent Institute has agreed to publish my Depression book, probably in mid-2013.  It’s been a long struggle.  I do plan on doing a book on the issues discussed in my blog, but given how long the Depression book took I won’t make any promises on timing.