Assume your dream policy gets enacted at the worst possible time

I plan to talk about the new paper by Gavyn Davies, Martin Brookes, Ziad Daoud and Juan Antolin-Diaz, but first a brief digression.

Suppose you were a long-time advocate of a stable monetary base, and called for the policy to be enacted in 1929.  Most likely policymakers would have rejected your advice—why change policy when the economy’s doing fine?  Then in October 1930 they notice that the US base has fallen 7% over 12 months, plunging us into a deep slump.  Now they enact the policy and it’s a complete disaster.  The actual monetary base rose sharply after October 1930, and yet the economy plunged ever deeper into depression.  A stable base policy at that time would have been even more contractionary.    The problem was that base demand rose sharply after October 1930 as bank failures increased.  So the policy would have been discredited. Bad timing.

Now suppose you propose M2 targeting in 1964, as a way of controlling inflation.  The Fed says we already have inflation under control; it’s only averaging a bit over 1% a year.  Then in 1979 they come back and take a second look, as inflation has risen to double digits.  But soon after M2 targeting is adopted, velocity falls and you go into deep recession.  And that’s just what you’d expect when inflation slows sharply.  After 3 years monetary targeting is abandoned.  Bad timing.  M2 targeting would work better if implemented when it was not needed!

Argentina had struggled with hyperinflation for decades, and finally adopts the currency board in the 1990s.  Then in the late 1990s the dollar soars in value due to the developing country economic crisis and the US tech boom, and the Argentine currency gets pulled up with the dollar, plunging them into deflation when all their competitors are devaluing.  Bad timing.

The lesson is that you need to propose a robust policy, something that will work even if implemented at the worse possible time.  That’s why QE alone is not enough (unless done in politically unrealistic quantities.)  QE is likely to be adopted precisely when the demand for base money is soaring, indeed precisely because the demand for base money is soaring.  Davies, et al, make a very good observation regarding Woodford’s NGDPLT proposal:

An inherent practical problem with NGDP targeting is precisely that it ignores that there might be, from time to time, slowdowns in potential growth. Assume that CBO’s estimate of potential output is correct, and that the Fed adopts NGDP targeting using Woodford’s proposed linear trend. If the announcement of the new policy is successful, an increase in inflation expectations would lower real interest rates, and stimulate the economy immediately.

The real output gap would gradually close but, critically, inflation would initially remain below or around 2%, since according to economic theory no additional inflation is generated before the economy operates at full capacity. At the point where real GDP reaches potential, however, there would still be a large shortfall in NGDP on Woodford’s estimate of the gap. Under his NGDP rule, the Fed would then need to keep to its promise and maintain interest rates fixed at zero, pushing real GDP above its potential level and spurring high inflation. But this higher inflation would not close any pre-existing price level gap because, as we pointed out before, there is no such gap. It would instead mean that the Fed would be producing a permanently higher price level. Inflation would continue rising for as long as output remained above its potential level.

The wording here is slightly confusing, but they make an important point.  If NGDP targeting aimed to close the large estimated NGDP gap from the pre-2008 trend line, then it’s quite possible it would push the economy above capacity, triggering high inflation.  Davies, et al, correctly point out that Woodford probably overestimated the trend line for real GDP.  But this would not be all that serious of a problem if the new policy were maintained forever.  You’d have a period of above trend inflation, and then inflation would settle down to 5% minus the actual trend growth rate in RGDP.   Even if it was 3% instead of 2% inflation, that would certainly not be a disaster.  But here’s what might be a disaster:

There is another, even longer term, problem with this approach. Faced with rising inflation and output above trend, the Fed would eventually decide it needs to choke off the rise in inflation through raising interest rates and tightening monetary policy. This would mean pushing the economy into recession””or, at least, growth below its trend rate for a period””to generate disinflationary pressure and lower inflation expectations.

So if Woodford’s proposal to make up the entire 14% undershoot in NGDP led to much higher inflation in a few years, the policy would be politically discredited and the Fed would tighten sharply, leading to another boom and bust cycle—just what NGDP targeting was supposed to avoid.  George Selgin and Larry White could correctly say; “I told you so.”  It would do no good to cry and moan that NGDP targeting would have worked if only allowed to operate for 50 years.  That’s not how politics works.

This is why I no longer favor returning to the old trend line, but instead favor only modestly higher NGDP growth for a few years, and then form a new trend line at what ever rate the Fed decides on.  It doesn’t have to be 5%, but to play it safe I would only change the trend line very gradually.  I’m a pragmatist, so I favor introducing my policy in such a way that it will do as little damage as possible, even if abandoned in 3 years.  No one can assume that their pet idea will be adopted forever.  That was the Achilles heel of the gold standard, a system that works far better if expected to last forever, then if faced with periodic episodes of panicky gold hoarding associated with fear of devaluation and/or abandonment of the system.  The gold standard doesn’t work well if people don’t expect it to last.

PS.  I have one major objection to Davies, et al.  They suggest that the price level is currently right on the trend line, and that a policy of level targeting would not call for any make-up right now.  I disagree.  I believe that they underestimated the inflation trend up to 2008, and overestimated it since.  Drawing trend lines is extremely tricky, and it’s hard to distinguish between a stable trend and one that’s changing in subtle ways.  Oil prices were much higher in 2008 than a few years earlier (and then crashed in 2009); that’s why consumer prices seemed to form a “bubble” in 2008. But unemployment was close to the Fed’s estimate of the natural rate of 5.6% at the peak of the bubble, and hence their own model suggests we should have been right on trend at that time.  And oil prices are still very high today!  I stand by my claim that the 1.2% inflation since mid-2008 shows were have undershot on the price level over the past 4 years, and that a price level targeting regime would call for higher inflation today.

HT: Saturos


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39 Responses to “Assume your dream policy gets enacted at the worst possible time”

  1. Gravatar of Greg Ransom Greg Ransom
    5. October 2012 at 07:14

    What if no one ever implimented your policy program but everyone — folks who never competently grasped your program — said they had.

    I think that happens a lot.

  2. Gravatar of ssumner ssumner
    5. October 2012 at 07:35

    Greg, Yep, and you need to take that into account when presenting your plan.

  3. Gravatar of bill woolsey bill woolsey
    5. October 2012 at 07:44

    I favor 10% nominal GDP growth for one year (a Volcker/Reagan nominal GDP recovery) and then 3 percent in the future. If the CBO is correct, this would close the output gap and allow for price level stability going forward.

    If the RBC people are right, then it would generate a 7.5% increase in the price level (inflation for a year) and then the price level would stabilize.

    If potential output is really at the trend of the Great Moderation, then it would only close about half of the output gap, leaving us nearly 6% below potential. However, given the new growth path of spending, I think that full recovery would be possible over the next 5 or six years with a mild deflation of prices. The price level then would end up about 6% lower (like 102) and then stabilize.

    The price level and wage level are both only about 2 percent below the trend of the Great Moderation. There has been very little adjustment. If potential output is subject to sudden 13% shifts in growth paths, then nominal GDP level targeting will result substnational instability in final goods prices. So? That is better than requiring nominal wages to adjust that amount.

    The only exception is if the amount people want to work changes 10% over a year or two. Then nominal GDP level targeting requires changes in prices and wages to no good purpose. (And this is what the RBC people really think. It is always the “Great Vacation” that is the problem.)

  4. Gravatar of Andy Harless Andy Harless
    5. October 2012 at 07:56

    I hate this “I’ll start my diet tomorrow” version of NGDP level path targeting. It makes a mockery of the whole approach if you don’t start the target path at a point where the economy was near potential. Inflation is the punishment for the economy’s failure to show adequate real growth, and I don’t think we should give even a partial pardon to such a huge transgression as we’ve seen over the past 5 years. We NEED a boom now because 5 years of hysteresis have reduced potential output in a way that will require some years of above-potential output to undo. The long-term unemployed and discouraged workers will not be re-integrated into the workforce without some years of difficult-to-satisfy demand. If that means slower growth, or even a recession, afterward, so be it. That recession will at least be mitigated by the credibility of the NGDP targeting regime, a credibility that it won’t have if it’s instituted ad hoc without regard to a pre-existing trend.

    I haven’t read the Davies et. al. paper yet, but from your description, it seems their version of macroeconomics goes back to the adaptive expectations of the 1970’s. What happened to rational expectations? I’m far from 100% believer in RE myself, but surely if the path of NGDP is fully anticipated, it’s not going to have a dramatic boom-bust effect. There will be a boom of some sort, but it will be moderated by the anticipation of future tightening, more so the closer we come to the target, as the prospect of tightening becomes imminent.

    There might be a problem if the target horizon is too short, since it may take a while for markets to adjust, and because, if the real economy adjusts slowly, a too-short horizon might require too much inflation/disinflation to offset changes in real growth at target horizon. That’s why I’m not happy with one-year-ahead targets. I would like to see policy directed toward achieving the target at maybe a 4 year horizon, with the Fed using its judgment as to how best to approach the target. (In other words, if they think they can get there in one year without causing problems, fine, but cut them some slack if they think they need it.)

  5. Gravatar of dtoh dtoh
    5. October 2012 at 08:13

    This all seems obvious and hardly worth a discussion. How quickly you decide to get back to the trend line will determine the mix of real growth and inflation, but no one knows or will agree on the exact relation so any policy decision will certainly just be the result of a SWAG and some political calculus.

  6. Gravatar of Morgan Warstler Morgan Warstler
    5. October 2012 at 08:14

    “They suggest that the price level is currently right on the trend line, and that a policy of level targeting would not call for any make-up right now. I disagree. I believe that they underestimated the inflation trend up to 2008, and overestimated it since.”

    Man, PLEASE couldn’t you just say IF what you could get right now is 5% LT with no make VS. we keep doing what we’ve been doing, you would or would not take the deal?

    If not, say NO, it won’t work well enough to do it.

    There’s no clarity on how much you value the actual policy vs. the immediate call for inflation.

    —-

    No surprise Andy gets is backwards.

    “I hate this “I’ll start my diet tomorrow” version of NGDP level path targeting.”

    The DIET is actually raising rates Andy and going level right now. GORGING is lowering rates / QE.

    And inflation is NOT the punishment for bad fiscal policy which hurts growth.

    Inflation is an attempt to forgive bad fiscal policy.

    Up is down, black is white.

  7. Gravatar of ssumner ssumner
    5. October 2012 at 08:14

    Andy. I think you missed my argument. I agree that a NGDP targeting regime that tried to go all the way back would work fine, if it was allowed to work. But I don’t think it would be allowed to work. It would be quickly abandoned when inflation hit 7%, and then discredited. There’d be no more talk of NGDP targeting. I want NGDP to succeed in the short and long run, even if it succeeds slightly less in the short run. Even 6% NGDP growth for a couple years would quickly lower the unemployment rate; productivity growth has virtually stopped. (see my next post.)

    I don’t see RGDP is being anywhere near 14% below trend, more like 5%. Woodford’s plan could create a lot of inflation.

    And I would add that the argument that we should go all the way back must have some sort of time limit. Suppose 30 years down the road we are still 14% below NGDP trend. Do we still want to go all the way back, despite the fact that by then all wage, price, and debt contracts would have adjusted to the new reality? Obviously not.

    On the other hand once a NGDP targeting regime is in place, I favor going 100% of the way back all the time. So we are in complete agreement there. But we don’t currently have a 5% NGDP targeting regime.

    Bill, I’m a bit closer to your view, but see my reply to Andy.

  8. Gravatar of Bill Ellis Bill Ellis
    5. October 2012 at 08:38

    Scott, I seem to remember you arguing that getting back to trend with NGDP targeting would not be inflationary … Was I confused ?

  9. Gravatar of Mark A. Sadowski Mark A. Sadowski
    5. October 2012 at 09:01

    “I have one major objection to Davies, et al. They suggest that the price level is currently right on the trend line, and that a policy of level targeting would not call for any make-up right now. I disagree. I believe that they underestimated the inflation trend up to 2008, and overestimated it since. Drawing trend lines is extremely tricky, and it’s hard to distinguish between a stable trend and one that’s changing in subtle ways.”

    Scott,
    The thing about the Gavyn Davies et al. paper that really bothered me the most were his trend lines. They’re nothing like the trend lines I’ve seen most Market Monetarists discuss. (For examples I refer commenters to recent posts by Marcus Nunes, Mayor Bill Woolsey and non-MMer George Selgin.) So where on earth is he getting them? It turns out he’s simply following Mike Woodward’s lead.

    On page 45 of Woodward’s Jackson Hole paper he states that he fitted a log-linear trend line to NGDP over 1990Q1 through 2008Q3 and that NGDP was 15.6% below trend in 2012Q2. If you look at Figure 13 it’s clear Woodward didn’t simply fit the trend line to the endpoints, so I assume he used some other technique.

    This morning I log-linearized NGDP, RGDP and PCEPI over the period in question and fitted least linear squares trend lines over the data and got results very similar to what Davies and Woodward are getting. My estimates show that in 2012Q2 NGDP, RGDP and PCEPI are 14.9%, 14.2% and 0.0% below trend respectively. So fitting the trend lines this way one finds that the price level is exactly on trend.

    This is just something you may want to consider when you discuss the paper by Davies et al.

  10. Gravatar of ssumner ssumner
    5. October 2012 at 09:29

    Bill, No, I don’t think I made that argument.

    Mark, There’s a huge difference between a statistical trend line, and a price level trend relevant for level targeting. You need to go beyond statistical issues and think about economic issues. The Fed was doing inflation targeting in 2008, not P-L targeting. Unemployment was near the natural rate. There is absolutely no good economic reason not to start the trend line in mid-2008, especially since oil prices were high both then and now, and unemployment was at the natural rate.

    Again, the Fed was doing inflation targeting back in 2008–which means they wanted 2%/year inflation between 2008 and 2012. They fell way short.

    Of course the impact of oil on the price level shows the folly of both inflation and P-L targeting.

  11. Gravatar of RebelEconomist RebelEconomist
    5. October 2012 at 09:53

    If you want an NGDP target to last, my advice would be to err on the tight side, to dispel any suggestion that what has changed is not so much the monetary policy target as the authorities’ willingness to “take the punchbowl away”. Any initial relief as the new target allows an immediate relaxation of monetary policy is likely to be more than undone when the target first mandates tightening, as the UK found to its cost when it joined the ERM: http://reservedplace.blogspot.co.uk/2011/11/easing-in.html

  12. Gravatar of Mark A. Sadowski Mark A. Sadowski
    5. October 2012 at 10:28

    Scott,
    I just noticed I repeatedly called Woodford “Woodward”.

    This is one of the perils of trolling Economist’s View. Post Keynesians and MMTers keep shoving stuff under your nose showing that neoliberal Democrats like Bob Woodward are no different from Republicans so you should either vote for Nader or stay home on election day. (Good grief!) I’m going to EV mainly to read and post on economics issues and could care less how horrendously evil and hypocritical the Democrats supposedly are.

    I soooo wish the Crazy Season was over already!

  13. Gravatar of JKH JKH
    5. October 2012 at 12:17

    Maybe you’ve already done this sufficiently, but for presentation purposes you might structure your proposal in a formal way (top-down) into two phases – transitional and permanent – to add definition to the separate, one-time nature of the upfront problem, and lessen any potential confusion of that with what’s expected more permanently.

    You say you favor this for pragmatic reasons. That’s fine, but doesn’t this suggest that you implicitly favor an independent inflation upper bound as an additional constraint on NGDP targeting in permanent mode?

  14. Gravatar of Andy Harless Andy Harless
    5. October 2012 at 13:32

    I don’t think inflation would hit 7% (at least not core inflation, and provided that the Fed has enough time to catch up with the NGDP target path), and even if it did I don’t think NGDP targeting would be abandoned, unless Congress forced the Fed to abandon it (which would require a cloture vote in the Senate and therefore wouldn’t happen either). Presumably the Fed would have unbiased forecasts of inflation for the catch-up period, so we would know beforehand if the inflation rate was expected to hit 7%. And presumably the Fed would take this into account in setting its projected convergence path, so it probably would allow for slow enough convergence to the target path that inflation would never be expected to hit 7%. Granted, the inflation forecast could turn out to be wrong, and inflation could actually hit 7%, but this is just the sort of trial that, if it were passed (i.e., if the Fed stuck to its target), would give NGDP targeting long-run credibility. I presume the Fed would want to purchase that credibility once it was on offer. Your approach, on the other hand, is more of a “nothing ventured, nothing gained” approach that makes NGDP targeting look like a temporary expedient, which might then be abandoned if the subsequent business cycle gets difficult.

    Now to say that RGDP is only 5% below trend (and by trend I assume you mean potential) is perhaps valid in a sense, because 5 years of depression have taken their toll on potential. But much of that toll can be reversed: businesses, for example, can be induced to hire the long-term unemployed, and workers can be drawn back into the labor force, but these things can only happen if output is allowed to go above potential for a while. So in a sense it is a self-fulfilling prophecy to say that the trend of potential output has fallen dramatically (as “currently 5% below” would imply). If we believe that and then act on it by choosing a conservative NGDP target path, then our belief will be realized, but if we believe potential has not slowed quite so much and choose an aggressive target path, then that belief may also be realized.

    Also, a more aggressive target path gives the Fed a lot more ammunition. I don’t think such a target path would require 7% inflation, but it will certainly require inflation rates that would normally be out of the current Fed’s comfort range. But that is exactly what the Fed needs, as Krugman would say, “committing to be irresponsible” and thereby allowing real interest rates to go more negative. The magic of an aggressive NGDP target is that it allows the Fed to commit to a policy that it would otherwise consider irresponsible but to do so in a way that is actually time-consistent (i.e. responsible).

    And I would add that the argument that we should go all the way back must have some sort of time limit.

    I would argue that it has to have a very specific time limit, namely one full business cycle (and by “full” I mean going back to when the economy was at potential, so 1936 would not be the peak of a full business cycle in this sense). I mean, it would be silly to go back to 1979 or 1989 or 1999 (or maybe not, but this comment is too long already, so I’m not going to make that argument), but it makes sense to go back to 2007. If we just go back to 2010, we’re basically giving up on full employment; we’re saying that we intend to make this depression partly permanent. The nice thing about 2007 is that it is preceded by about two decades of fairly smooth NGDP growth. Why can’t we aspire to return to that well-established trend rather than going off on a completely new trajectory?

  15. Gravatar of Andy Harless Andy Harless
    5. October 2012 at 13:45

    OK, I’m going to make the argument I said I wasn’t going to make. Here’s why you might want to go back to 1999 or even 1989. It’s a compromise between purists like me who insist on using a business cycle peak and pragmatists like Scott who want the target path to be conservative enough to avoid forcing the Fed to do something it might not be willing to do. First of all, according to most contemporary guesstimates, a 5% NGDP path for the long run is probably no longer consistent with the Fed’s 2% inflation target. Most people seem to expect slower growth of potential in the future, partly for demographic reasons and partly because they’ve just become pessimistic about the Solow residual. So fine. Why not use, say 4.5%, and if you want to avoid too much inflation in the short run, you can do so by choosing an earlier start date. I haven’t done the math, but presumably, if you choose 1999, there will be a lot of negative catch-up for the previous business cycle, and this will partly offset the positive catch-up for the current business cycle.

  16. Gravatar of ssumner ssumner
    5. October 2012 at 17:18

    JKH, No, once in effect I completely ignore inflation.

    Andy. Here’s where we disagree. I think a lot of wage and price adjustment has alreay occurred. That means we do not need to get anywhere near the old trend line to get back to full employment. So I see nothing defeatist about my proposal. If NGDP grew at 6% for a few years people would be talking about a “boom.” That kind of growth would also lead to a lower natural rate of unemployment, which would help even more.

  17. Gravatar of James in London James in London
    5. October 2012 at 22:25

    That’s a very good and important point, if true. I’ve worried about how much extra, excess, NGDP, it might take to get those poorly educated, unskilled, long-term back into work (or off their sofas, as the Daily Mail/Republicans might say). If you think most of their wage and price adjustment has already occurred then that really wouldn’t be long. Very interesting.

  18. Gravatar of Assume your dream monetary policy gets enacted at the worst possible time « Economics Info Assume your dream monetary policy gets enacted at the worst possible time « Economics Info
    5. October 2012 at 23:01

    […] Source […]

  19. Gravatar of Morgan Warstler Morgan Warstler
    5. October 2012 at 23:29

    From God’s lips to Rebel’s ears;

    If you want an NGDP target to last, my advice would be to err on the tight side, to dispel any suggestion that what has changed is not so much the monetary policy target as the authorities’ willingness to “take the punchbowl away”.

  20. Gravatar of Andy Harless Andy Harless
    6. October 2012 at 05:05

    Scott,

    I think you’re misunderstanding my argument. I don’t necessarily disagree that a lot of wage adjustment has occurred already. But here are my points:

    1. We need to be above full employment, not just at full employment, to absorb workers who are going to be difficult to reabsorb.

    2. We should set a precedent that, when the economy underperforms in real terms, it gets hit with an offsetting amount of inflation, even if that amount is large. If we don’t do it this time, it’s like saying, “I start my diet on the next business cycle.”

    3. A higher target is easier to hit, because it allows for a more negative real interest rate (among other things).

  21. Gravatar of JKH JKH
    6. October 2012 at 05:17

    “No, once in effect I completely ignore inflation.”

    That’s the crux of why I think NGDP targeting will never be implemented.

    What you’re doing is taking a very pragmatic and prudent approach to the transitional implementation of NGDP targeting. It’s also artful in the sense that it lulls the observer into a false sense of assurance about bounds on inflation risk – overlooking the fact that there is no such assurance in the long run, since you eventually intend to “completely ignore inflation”.

    Your concern about transitional capacity and “manageable” catch up rates of real growth and rates of inflation is well taken, I think. And your approach is more prudent that what appears to be suggested in that particular regard by Woodford, IMO.

    This “conservative” approach to a “manageable” transition trend line assumption is inherently equivalent to setting an upper bound for inflation.

    Whether you’re doing that to satisfy popular perception, or because you actually believe there is that risk – is not that relevant. Either way, you’re doing it to get NGDP targeting implemented.

    In the same way, you must consider popular perception in the future permanent tail of NGDP targeting implementation. The reason for whatever you do – whether it’s to satisfy popular perception or because you actually believe there is some risk – is not that relevant. You’re doing it to get NGDP targeting implemented.

    But I think the point is that you need to be consistent in your approach to risk in order to have this whole thing accepted – transitional phase and permanent phase. And I think it’s inconsistent to have an implied inflation upper bound during transition, and not to have one permanently.

    The former situation says “trust me, I accept the view that there is an inflation risk, so we need an upper bound”.

    The latter says “trust me, there is no inflation risk, we don’t need an upper bound, and you should accept that”.

    That second judgement is arbitrary and subjective.

    I don’t think NGDP targeting will ever be implemented without an understood inflation upper bound on a permanent basis. In which case it won’t be NGDP targeting at all – because the nominal target will always be subject to the risk of adjustment on the basis of the risk to the upper bound for inflation being pierced.

    The material question is the probability for whether or not that upper bound would ever become binding on an otherwise fixed NGDP target.

    If you believe in your reasoning for not having an inflation upper bound, then you shouldn’t mind having one that reflects you own views on inflation risk, and being upfront in announcing it – whether its 3 per cent with a 5 per cent NGDP target, or 7 per cent with a 5 percent NGDP target.

    Or, if you truly believe there is no upper bound, then you won’t mind 10 per cent inflation with a 5 per cent NGDP target. At the end of the day, this approach amounts to – trust me, the current rate of inflation will NEVER be a risk under NGDP targeting. I suggest that approach will never be accepted or implemented.

  22. Gravatar of Saturos Saturos
    6. October 2012 at 05:37

    JKH, inflation is a sustained rise in the price level (which I define with the GDP deflator). So to have 10% inflation, year on year, under a 5% NGDP growth path, you have to have 5% negative real growth year on year. What are the odds of that happening, under monetary stability? And if we had a brief supply shock giving us 5% negative real growth, with 10% inflation as a symptom of that, then it’s absolutely right for the monetary authorities to ignore that as something to respond to, instead pointing to the real disruption of supplies and the price system correctly reflecting that real scarcity. People need to be taught to think like that, and under monetary stability they can be.

    So Scott can say, there is no “inflation” risk (understanding that term correctly as prices spiralling upwards due to excess “demand”) if you’ve got nominal spending on a stable growth path. But no one is going to worry anyway as the long run price level would grow quite stably under NGDPLT.

  23. Gravatar of ssumner ssumner
    6. October 2012 at 05:47

    Andy, You said;

    “We should set a precedent that, when the economy underperforms in real terms, it gets hit with an offsetting amount of inflation, even if that amount is large.”

    I was making this argument frequently in 2009 ands 2010, so I certainly know where you are coming from.

    I don’t worry much about people being hard to employ—unless we have a high minimum wage and extended UI.

    I also don’t worry about NGDP targets being hard to hit. If we set the target and do level targeting it will be easy to hit.

    As a practical matter we are on the same side. For any plausible Fed policy over the next few years both you and I will call for “more.” They aren’t going to do as much as I would like. This battle is really over the next cycle—and in that case I’ll agree with you 100%.

    JKH, Saturos is right, there is no such thing as “inflation risk.” The problems wrongly believed to be caused by inflation are either caused by fast NGDP growth (AD shocks) or falling RGDP (AS shocks.) Inflation per se is not a problem at all.

  24. Gravatar of JKH JKH
    6. October 2012 at 06:15

    For example, if NGDP grows at 8 per cent, with 5 per cent inflation and 3 per cent real, for several years, on the way to closing the gap against NGDPL at a defined 5 per cent trend line, you see no idea of “risk” in current inflation at 5 per cent? When would you start tightening policy – before or after convergence – and why?

  25. Gravatar of Saturos Saturos
    6. October 2012 at 06:25

    Well he would tighten after convergence, obviously. But you’re right, there is a public credibility issue, so as you’ll see if you read the post at the top of this page, that is exactly why Scott advocates going to a lower trendline. And at that lower target trend path, the gap should be closed by excess growth in real output, not prices, which closes the unemployment gap. And after that we get our normal 2% inflation. So we really shouldn’t worry about too high prices, there is no “promise to be irresponsible”.

  26. Gravatar of Morgan Warstler Morgan Warstler
    6. October 2012 at 06:25

    2. We should set a precedent that, when the economy underperforms in real terms, it gets hit with an offsetting amount of inflation, even if that amount is large. If we don’t do it this time, it’s like saying, “I start my diet on the next business cycle.”

    This is idiotic and laden with moral hazard. Govts. CAUSE economies to under perform. Inflation is forgiveness of their failures.

    Scott, is trying to get out of it when he qualifies it with:

    “unless we have a high minimum wage and extended UI.”

    That is not enough…

    Let’s say it the right way:

    IF Andy wants to see inflation used as “punishment” he must first deliver us a government that runs without high UI and high minimum wage.

    And while we’re at it, I want low taxes, 2% YOY productivity gains from public sector, and regulations that end without re-enactment.

    And THEN Andy can treat inflation as a punishment, if he wants it, he’ll deliver whats required in trade.

  27. Gravatar of JKH JKH
    6. October 2012 at 08:00

    Saturos,

    “And at that lower target trend path, the gap should be closed by excess growth in real output, not prices, which closes the unemployment gap.”

    That’s right, and I acknowledged that in my comment.

    But what you just said there indicates the management of inflation risk (“not prices”).

    “And after that we get our normal 2% inflation.”

    And then what I said is that this is just a hope. There’s no risk management of inflation there. You just deemed inflation is no longer a risk in the permanent stage, where you clearly acknowledged it as a risk in the transition stage. That’s the inconsistency I noted. You are declaring in effect that inflation risk is binary for this purpose – it exists in transition, but it doesn’t exist in permanence. I don’t believe that risk management of that type is binary. It’s not consistent to have an implicit upper bound for inflation in transition, but not to have one in permanence.”ƒ

  28. Gravatar of Negation of Ideology Negation of Ideology
    6. October 2012 at 08:04

    Of course, any new policy regime requires a transition plan. Currently, we have a dual mandate but in practice we target inflation (well, not exactly, but sort of). So it seems to me the transition should involve inflation. Here’s my imperfect suggestion:

    1. Target 7% NGDPLT growth during the transition.
    2. End the transition when inflation hits some pre-defined criteria, e.g. (PCE) is above 3.5% for two years in a row, or one year over 5%. Or perhaps when PCE has returned to pre-cisis trend.
    3. After the transition, target 5% NGDPLT growth forever and ignore inflation.

    Step 2 is the part that I believe needs the most work. It needs to be pre-defined so we can end discretion and everyone knows what to expect.

    And by the way, in the unlikely event that we can have 7% NGDP growth forever without having inflation over 3.5% – well, that’s a feature not a bug. Of course, that’s impossible.

  29. Gravatar of James in London James in London
    6. October 2012 at 08:18

    “JKH, Saturos is right, there is no such thing as “inflation risk.” The problems wrongly believed to be caused by inflation are either caused by fast NGDP growth (AD shocks) or falling RGDP (AS shocks.) Inflation per se is not a problem at all.”

    Scott, what do you consider these problems to be, exactly? Sometimes you riddle too much.

  30. Gravatar of Saturos Saturos
    6. October 2012 at 09:48

    Excess taxes on capital (because it’s hard to index the tax code), menu costs, shoeleather costs (serious under hyperinflation), and distortion of the price mechanism (esp. ex ante vs. ex post returns on investment under non-indexed contracts, tends to really hurt the stock market).

  31. Gravatar of Saturos Saturos
    6. October 2012 at 09:49

    That’s for demand-side inflation. Supply side inflation is merely a consequence of falling real income (real production), not the cause of it.

  32. Gravatar of John John
    6. October 2012 at 11:14

    This is garbage.

    “The real output gap would gradually close but, critically, inflation would initially remain below or around 2%, since according to economic theory no additional inflation is generated before the economy operates at full capacity.”

    Have people forgotten even the theoretical possibility of stagflation?

  33. Gravatar of Gavyn Davies Gavyn Davies
    6. October 2012 at 22:36

    Scott
    Thank you very much for this detailed reply. On the point about the trend construction, we will come back to you after further thought. We were trying to use the same method which Michael Woodford used for the NGDP target in order to be consistent.

  34. Gravatar of James in London James in London
    6. October 2012 at 23:12

    Scott/Saturos. Am still puzzled by the “inflation per se is not a problem at all” comment. Because “inflation per se” doesn’t exist?

  35. Gravatar of Prakash Prakash
    7. October 2012 at 00:11

    Scott,

    What are your path ideas for nominal wage level targetting? If Tyler cowen is right in the analysis that the US have had a great stagnation for a long time, would you prefer a nominal average wage level target or a nominal median wage level target, if the new policy were to begin now?

  36. Gravatar of Bill Woolsey Bill Woolsey
    7. October 2012 at 10:47

    The CEP price index is the wrong index to use. The GDP deflator is the correct one.

    Of course, the price level should not be targeted at all.

    I don’t start at a business cycle peak or 2007, I start in 1985–early in the Great Moderation.

    The GDP deflator is about 2 percent below trend.

    Real GDP is 13 precent below trend.

    That doesn’t mean that real GDP can quickly rise back to that trend. CBO argues that it cannot.

    Employment is 9 percent below trend.

    But if employment returned back to trend, and productivity has continued as before, then real GDP would get pretty close.

  37. Gravatar of ssumner ssumner
    7. October 2012 at 12:05

    Thanks Gavyn,

    Prakesh, Good question, I suppose median wages, but haven’t given it much thought.

    Bill the deflator being 2% below trend sounds plausible to me.

    James, problems supposed caused by inflation (like debtor/creditor unfairness and excess taxes on capital) are actually more closely correlated with unstable or excessive NGDP growth.

  38. Gravatar of Martin Brookes Martin Brookes
    10. October 2012 at 03:12

    Scott

    This is from Gavyn and his co-authors.

    In your blog you raise the point that we might mis-specify the trend for the price level, saying this is your major objection to our paper. You say high oil prices might have affected the behaviour of inflation before and after the recession:

    “I stand by my claim that the 1.2% inflation since mid-2008 shows we have undershot on the price level over the past 4 years, and that a price level targeting regime would call for higher inflation today.”

    We are unclear which inflation rate has averaged 1.2% since mid-2008. The core personal consumption expenditure deflator (PCE) excludes some of the volatility of energy and food prices. The average annualised increase in the core PCE deflator since June 2008 has been 1.5%. Extrapolating a 2% trend line since that point gives an accumulated price level gap of 2% as of August 2012. This is only a modest gap. Alternative assumptions can be used to check the robustness of our results. The 1990-2007 trend line implies a price level gap of 1.3% today; 2004-2007 implies a 3% gap, though core inflation averaged 2.3% during this period.

    Whichever period one uses gives only a modest price level gap today, leaving the vast majority of the 14% nominal GDP gap to be accounted for by a shortfall in real output. This is in marked contrast to two episodes one might take as comparators, namely the US during the depression, or Japan from the late 1990s onwards. In each of these cases, the price level deviated materially (more than 20%) and increasingly from the prior trend.

    The danger we highlight in our paper remains, namely an attempt to close the claimed GDP gap through a target for the level of nominal GDP could lead to unstable and potentially damaging monetary policy. This is the consequence of the small price level gap.

    Gavyn Davies et al, Fulcrum Asset Management

  39. Gravatar of Saturos Saturos
    10. October 2012 at 06:22

    Gavyn Davies et. al, the price level (actually the output-gap adjusted core price level) gap is only a proxy for the gap that really needs to be closed: the gap between nominal hourly wage rates (x potential labor hours) and total nominal income. That gap has not closed at all: https://twitter.com/i/#!/_Srijit/media/slideshow?url=pic.twitter.com%2F75qDdc3G

    Why would closing the output gap be destabilizing? You might think the gap to potential output is now permanently smaller, but that’s a different matter.

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