Marcus Nunes directed me to a recent post by Michael Hatcher, discussing NGDP targeting:

(1) To the extent that future output is uncertain, nominal GDP targeting does not provide an anchor for inflation expectations. Nominal GDP targeting does provide an anchor for nominal spending. What it does not do, however, is provide a clear focal point for inflation or price level expectations. To see this, note that a nominal GDP target of N* will be met when P.Y = N*, where P is the price level, and Y is real GDP. Hence, the central bank should promise to set P = N*/Y, making the price level countercyclical. Since future output is uncertain, there is no fixed point on which price level expectations will gather given a promise to move the price level inversely with output. The same reasoning also applies to inflation, except that expected future inflation will be inversely related to expected output growth under (credible) NGDP targeting. All this matters because having a clear focal point for inflation or price level expectations is crucial for keeping actual inflation low and stable. Indeed, there is good evidence from bond yields that inflation targeting has lowered inflation expectations and reduced inflation uncertainty (see here and here). This would be lost under nominal GDP targeting, putting the economy at risk of higher and more variable inflation.

There are several points that need addressing.  A switch to NGDP targeting does not necessarily result in higher or lower average inflation; rather inflation might become more countercyclical.  The trend rate of inflation is just as likely to fall, as it is to rise.  It’s not even clear that inflation would be more unstable, as inflation targeting is probably not the best way to stabilize actual inflation.

But there’s a far more important issue here.  In my view, inflation expectations don’t matter very much; it’s NGDP growth expectations that matter. The so-called “welfare costs” of inflation, such as “shoe leather” costs and the cost of excess taxation of investment income, actually apply better to NGDP growth, for the simple reason that NGDP growth is more closely tied to nominal interest rates than is inflation.  So if inflation expectations do become more unstable, that’s actually a point in favor of NGDP targeting, as long as NGDP growth expectations become more stable.

(2) Nominal GDP targeting is not easy to communicate to the general public. Proponents of nominal GDP targeting have argued that it would be easy for central banks to communicate monetary policy in terms of a target for nominal spending. But as I argued in point (1), the problem comes when individuals attempt to forecast the two variables (price level and real GDP) that make up nominal GDP. For instance, the guidance nominal GDP targeting gives about future inflation is minimal, since there are an infinite number of price level and output combinations (or, equivalently, inflation rates and growth rates) which are consistent with any given nominal GDP target. Hence, any inflation rate is desirable, given wild enough swings in output. In such circumstances, central banks would presumably be forced either to deviate from the nominal GDP target (losing credibility) or to specify circumstances in which the target would not apply (big shocks). But then the target itself becomes state-contingent and its simplicity is lost.

I don’t see why central banks would deviate from NGDP targeting in response to wild swings in inflation, because it is NGDP growth, not inflation, that matters.  It is NGDP growth shocks that destabilize labor markets and financial markets, not inflation shocks.  Indeed there was a positive inflation shock in the first half of 2008, and yet NGDP growth was slowing.  In retrospect, it is NGDP growth that should have been stabilized in 2008—that was the much more important shock. Unfortunately, the Fed and ECB paid too much attention to the inflation shock in mid-2008, and as a result monetary policy was too tight.

The public would actually find it much easier to understand NGDP targeting, whereas the public is completely mystified by inflation targeting. They don’t even know what inflation is. The public thinks that inflation should measure the rise in the cost of living, the way we live now.  Thus they would include the average amount of money that people spend to buy a TV set in a price index, whereas we actually put in the price of a quality-adjusted TV set, which is vastly different.  Even worse, they don’t understand the purpose of inflation targeting.  In 2010, core inflation had fallen to 0.6% and Bernanke announced the Fed would try to increase inflation.  The public should have jumped for joy; “Great, we are going to get closer to the inflation target of 2%”.  Instead there was outrage that the Fed was trying to increase the “cost of living” for Americans who were already suffering from recession.

When the public thinks about “inflation” they tend to implicitly hold their nominal income constant.  Thus they wrongly think that inflation lowers their living standard, and they thought Bernanke’s 2010 policy would reduce their real income. Implicitly they equate “inflation” with “supply-side inflation.” But of course the Fed has no impact on supply-side inflation, it can only influence demand-side inflation. And an increase in demand-side inflation (which is what Bernanke was trying to achieve in 2010) would actually increase the real incomes of Americans.

Now let’s assume that in 2010 Bernanke had said that a healthy economy requires adequate growth in the incomes of Americans.  Suppose he said that the economy was weak due to slow growth in incomes, and that the Fed would try to generate 5% growth in our incomes.  That would have probably provoked much less outrage from the general public than his call for higher inflation.  It would also have had the merit of being more accurate, as Bernanke was actually trying to boost demand (NGDP) and he hoped most of the rise would be in RGDP, not inflation.  When he suggested the need for higher inflation in 2010, he actually meant that he wanted more NGDP, hoped it would be mostly RGDP, but expected it would also lead to more inflation.

3)Credibility would be strained in the face of demand shocks under nominal GDP targeting. Scott Sumner and others have argued that one benefit of nominal GDP targeting is that it provides flexibility in response to supply shocks. It would not require, for example, that the central bank raise interest rates in response to stagflation: a rise in inflation would be permitted, temporarily, while output is weak. But large supply shocks are fairly infrequent. If we look instead at demand shocks, nominal GDP targeting looks less attractive. Suppose, for example, that the nominal GDP target is 100, but that nominal GDP overshoots to 105 due to the price level and output being higher than expected in the face of a positive demand shock. Nominal GDP is now at the level it should be next year, assuming an NGDP target path that rises by 5% per annum.  As a result, the central bank now wants nominal GDP to flatline next year. It is therefore faced with three unattractive choices: keep both inflation and output growth at zero; combine positive inflation with negative output growth; combine positive output growth with deflation. The likely result is that the central bank would not follow through in these circumstances, and its credibility would be eroded. Enough such episodes could reduce credibility to the point where nominal GDP targeting would have to be abandoned.

Once we factor in negative demand shocks and the zero lower bound on nominal interest rates, things look even worse. For instance, suppose that nominal interest rates are near the zero lower bound and nominal GDP undershoots to 95, i.e. 5% below the target of 100, due to a series of negative demand shocks that lower the price level and real GDP. Now, given trend nominal GDP growth of 5%, the central bank would have to promise to raise nominal GDP by 10% next year in order to meet the new target of 105 (=100*1.05). Ten percent(!) – through inflation or output growth, or some combination – when the economy is at the zero lower bound. What central bank can credibly promise that? That would take a massive amount of credibility, probably too much to be plausible in practice.

Here I think Hatcher partly misses the point.  The main purpose of NGDP targeting is to reduce the severity of demand shocks. For instance, in mid-2008 inflation in the US had risen well above target, and hence the Fed tightened monetary policy, causing NGDP to fall 3% over the next year.  This was a powerful negative demand shock, caused by the Fed’s tight money policy.  This shock made the financial crisis much worse, and also sharply increased unemployment.  Under NGDP targeting the Fed would have had a much more expansionary monetary policy in late 2008, and hence the demand shock would have been much smaller.

Hatcher might reply that even with the best of intentions there would still be negative demand shocks under NGDP targeting, as monetary policymakers are not perfect.  I agree.  But the make-up required to reach the old trend line would actually be stabilizing under NGDP targeting.  For instance, if the Fed makes a mistake and NGDP growth overshoots the target, then they need to gradually reduce NGDP to bring it back to the trend line.  Normally a policy of reducing NGDP growth might cause a recession.  But if you start from a position where NGDP has overshot the target, then you are starting from a position where output and employment are above their natural rates.  So the contractionary monetary policy is actually stabilizing, as it brings you closer to the natural rate.  Something like that happened in Australia in 2008, when the economy (NGDP) had overheated.  A sharp slowdown in NGDP growth in 2009 did not cause a recession in Australia, but rather brought output and employment closer to the natural rate.  So these moves to bring NGDP back to the trend line would actually be less controversial than you might assume, if you simply had looked at the NGDP move without reference to where the economy was relative to the natural rate.

How about the zero bound problem?  Ironically, Michael Woodford endorsed NGDP level targeting a few years ago precisely because it does a better job of handling the zero bound problem.  When NGDP falls well below trend, it’s hard to reduce real interest rates under an inflation-targeting regime.  In contrast, under NGDP targeting you can call for a temporary period of above average nominal growth, which reduces interest rates relative to both inflation and (more importantly) NGDP growth.  Now of course there is still the underlying problem of having concrete policy tools that are effective at zero interest rates, and I’ve written zillions of posts on options for doing so.  But for any given policy tool, it would be more effective at the zero bound under NGDP level targeting (or price level targeting) than under inflation targeting.Here’s another way of thinking about it.  Asset prices are closely linked to changing expectations of two or three-year forward NGDP.  In late 2008 and early 2009, those expectations plunged, and this sharply depressed asset prices—also hurting the balance sheets of highly leveraged banks like Lehman Brothers.  Under NGDP targeting, two or three-year forward NGDP expectations are more stable, and hence asset prices are more stable. That would tend to reduce the severity of demand shocks.  In modern macro models, current moves in aggregate demand (NGDP) are closely linked to future expected changes in demand.

To summarize, the best argument for NGDPLT is not that it handles “shocks” better than other regimes such as inflation targeting, but rather that it recognizes that most so-called “shocks” are simply bad monetary policy, and NGDPLT makes for a more stable economy by reducing the frequency and severity of those monetary shocks.

PS.  I’ve been catching up on old podcasts from David Beckworth, which I missed the first time around.  This morning I listened to the one with Ramesh Ponnuru, which does a really nice job explaining the intuition behind NGDPLT.  The podcast with George Selgin provides another excellent perspective on the basic idea.

Back in July 2014, I made a prediction that 3% NGDP growth was the new normal, as soon as unemployment fell to the natural rate. At the time, that prediction raised some eyebrows.  The 12-month NGDP growth rate was running 4.5% in the second quarter of 2014, and rose to 4.9% in Q3.  The Fed’s estimate of the long-term growth trend was considerably higher than 3%, as were private forecasters.  But look what’s happened since:

The NGDP growth rate has fallen below 2.5% over the past 12 months.  That’s partly due to the falling oil prices, and I expect inflation to bounce back a bit. But I also expect the unemployment rate to stop falling soon, so I’m sticking with 3%, which looks increasingly likely as a long run NGDP trend.

Here’s what I said in July 2014:

3.  The Fed has a big NGDP problem.  It’s becoming increasingly clear that when the labor market recovers, RGDP growth will be very slow, maybe 1.2%.  Add in about 1.8% on the GDP deflator, and 3% NGDP growth looks like the new normal, assuming the Fed intends to stick with 2% PCE inflation targeting.  Bill Woolsey wins!!  Here’s the problem.  The Fed wants to do both of these things:

a.  Continue targeting inflation at 2%.

b.  Continuing to use interest rates as the instrument of policy.

But it won’t work.  At 3% trend NGDP growth, nominal interest rates will fall to zero in every single recession going forward.  The Fed will be spinning their wheels just when monetary stimulus is most needed.  At some point they will need a new policy instrument/target.  Lars Christensen has a very good post discussing a clever idea by Bennett McCallum, but in my view this idea works better for small countries than for the US, which is likely to follow the global business cycle.  NGDP futures anyone?  Level targeting?

4.  Unemployment is likely to fall to the natural rate (estimated by the Fed at 5.6%) quite quickly. There will be a debate about what to do next.  It will be the wrong debate.  The debate needs to be about where the Fed wants to go in the long run.  First figure out where you want to go in the long run, then adjust your short run policy as needed.  Otherwise the blogosphere debate will be like a bunch of drunken frat boys arguing about which street to take, when they can’t even agree on which bar they are going to.

As I expected, unemployment did fall to 5.6% fairly quickly, more rapidly than the Fed predicted.  And growth in both nominal and real GDP was slower than the Fed predicted.  So how was I able to beat the highly skilled Fed forecasters at their own game?

The answer is simple.  Way back in 2011 I noticed that this was a “job-filled non-recovery”, while most pundits were still talking about a jobless recovery.  That is, I noticed that RGDP was not recovering as expected, but the unemployment rate was falling rapidly.  And this process has continued up until the present.  By 2014 I had seen enough to regard this strange pattern as more than a fluke, rather as the new normal.  The asset markets (long term bond yields) were clearly signaling more slow NGDP growth ahead. Thus I figured that if the unemployment rate is falling rapidly, and NGDP growth is still only about 4%, you know that when the unemployment rate stops falling, the NGDP growth rate will slow dramatically.  And that’s exactly what happened.  The trick was to take the data seriously, and not assume we were going to return to some mythical “normal” level of NGDP growth.

Unfortunately, monetary policy remains just as dysfunctional as I feared.  The Fed still relies on interest rate adjustments in a world where we are going to be permanently close to zero rates, and at or below zero in every single recession where we need stimulus.  They have not adopted any of the new procedures suggested by elite economists (including Bernanke) for such a world, such as a higher inflation target or level targeting.  They are very reluctant to admit the obvious; their current policy regime is not working.

And the drunken frat boy metaphor still applies.  There are all these meaningless debates about whether to raise interest rates, with no consideration of what sort of NGDP growth rate is appropriate.  No debate about level targeting.  What are we trying to achieve? As a result, inflation has averaged well below 2% during the period of high unemployment, whereas under the Fed’s dual mandate inflation should average above 2% during slumps, and below 2% during booms.  They have things backwards and don’t even seem to realize it.

The Fed has thrown in the towel and admitted that they will not raise rates 4 times this year.  (The markets predicted 2 times, which itself may be an overestimate.)  How long will it take for the Fed to throw in the towel and admit that under its current operating procedure 3% NGDP growth is the new normal?  (Bullard will probably get there first–he has an open mind, and takes the data seriously.)  And how long until they realize that this sort of NGDP growth rate makes interest rate targeting almost useless as a monetary policy instrument?

PS. Think about this for a moment—the US real GDP grew about 1.2% over the past year, and the unemployment rate fell.  This disconnect between growth and unemployment also explains why I don’t expect the UK unemployment rate to rise very much after Brexit (I predicted a 50 basis point increase.)  My hunch is that Brexit will hurt UK GDP more than it hurts their job market.

PPS.  Another Trump lie, another promise broken.  But hey, the GOP convention is over now.  (Just to be clear, I do not think candidates should be required to release tax returns.  But if they campaign for the nomination on a pledge to release them before the election, then they should honor that pledge.  Now watch the Trumpistas tell me how naive I am.  “All candidates lie that they will release their tax returns, and then renege on the promise.  Don’t you understand that.”  Oh really, which ones specifically?

HT:  Tom Brown

When people come at NGDP futures targeting from a financial markets angle, they get hopelessly confused.  For instance, they worry about a potential lack of trading in NGDP contracts, whereas they should see that as a sign of success.

Today I’d like to suggest a different way of thinking about NGDP futures targeting.  In my view, the Fed can already do a perfectly adequate job of NGDP level targeting, even without tacking on futures markets.  So then why tack on the futures markets?  The answer is simple, they did not do a good job of maintaining NGDP stability during 2008-09, and NGDP futures targeting would force them to do so.

Go back to the 1990-2007 period, when NGDP rose at a pretty steady rate of around 5%/year.  And that was accomplished even without targeting NGDP.  Had they been targeting NGDP instead of inflation in the late 1990s, money would have been slightly tighter, making the resulting boom a bit milder, and (probably) also moderating the already very mild 2001 recession.  They did extremely well, and if they’d actually tried to target NGDP they could have done even better.

What about 2008-09?  It wasn’t just one mistake, it was several.  They focused on inflation, which was high in mid-2008, not NGDP growth that which was slowing sharply.  They focused on (high) past inflation, not TIPS spreads that showed falling inflation expectations late in 2008.  They focused on rescuing banking, not maintaining adequate AD.  (Indeed Bernanke basically admitted this failing (in his memoir) for the specific September 2008 meeting.)  They were squeamish about using unconventional policy instruments aggressively enough (although rates didn’t even hit zero until December 2008).

Obviously if there had been a NGDP futures policy in effect in late 2008, I would have been selling NGDP futures short like crazy.  Lots of other people would have as well, and the Fed would have been exposed to massive losses.

At this point many people get confused, assuming this is how I think things would have actually played out.  Not likely. The Fed would have been terrified of losing a boatload on money on bad NGDP bets.  Imagine explaining to Congress that you screwed up monetary policy so badly that you created a Great Recession, and to top it off you lost zillions of taxpayer funds.  It wouldn’t happen that way.

Instead, the real purpose of NGDP futures markets is to put the Fear of God into the FOMC.  They force it to do what it was already quite capable of doing, but held back due to either ignorance or fear of aggressive use of unconventional instruments.  Ironically, with a 5% NGDP target in 2008, level targeting, we would never had hit the zero bound, and we would never have had to rely on unconventional tools.  But even if we did, the Fed would have done “whatever it takes” to keep NGDP expectations on target.

Because I think the Fear of God would have made the Fed do what it should have done in any case, I think it’s quite possible that there would be little trading of NGDP futures contracts.  But I don’t care, because that “little trading” would be a sign of success.

PS.  Think of this as a variation of Lars Christensen’s famous “Chuck Norris effect”.  In this case Chuck is in the FOMC conference room in 2008, standing right behind Bernanke.  He whispers the following in Ben’s ear:

In your heart, what policy do you think is most likely to provide on-target aggregate demand in 2009?  The weak plan your staff prepared, or the aggressive steps you recommended to the Japanese back in 1999?  Keep in mind that I have a club in my hand, and plan to beat you all senseless if two things happen:

1.  Your plans fails to provide on target NGDP expectations.

2.  The market ends up being right and you end up being wrong.

OK Ben, deep down what do you think the Fed needs to do to provide 5% NGDP growth in 2009?

I want FOMC members to quake in their boots, and adopt a policy stance that roughly balances the short and long positions.  If that “balance” occurs with zero trades, that’s fine with me.  Indeed I hope they are such cowards that they refuse to take a stand, and meekly adjust the base until the long and short positions are balanced.  But if they want to take a bold stand  . . . well let’s just say I hope it works out better than when they overruled market forecasts, and predicted 4 rate increases in 2016!

PPS.  An update to Noah Smith’s recent post provides a great example of how thinking about this market from a finance angle throws people off.  Smith says:

Sumner seems to have thought very little about how markets actually become efficient. Scott, you need price discovery.

That’s not what NGDP futures targeting is all about.  It’s not price discovery, the price is pegged at 5%, it’s monetary instrument setting discovery.  I would recommend Noah look at Bernanke and Woodford’s 1997 JMCB paper, which makes it very clear that for this futures targeting approach to work it must be about forecasting the instrument setting that is appropriate, not about price discovery.  (I wonder if John Cochrane has also “thought really little about how markets become efficient”.)

Here’s an analogy.  The old international gold standard was not about the “discovery” of the proper nominal price of gold; it was about the discovery of the monetary base that would result in equilibrium occurring at the target price of gold.

And please don’t anyone tell me that the gold standard did not provide macro stability–I know that.  But it did stabilize gold prices, and NGDP targeting would stabilize NGDP expectations.  And (unlike stable gold prices) that’s a really good thing.  With stable NGDP expectations we will no longer have events like 2008-09.

If Noah Smith wants to seriously challenge the policy he needs to provide a plausible argument for large and time varying risk premia in the NGDP futures markets.  So far, no one’s been able to do that.  But that’s the sine qua non of any criticism.  Otherwise, I simply don’t care.  Manipulation? Who are the victims?  And did this occur under Bretton Woods?

And if it didn’t work, worst case is I get rich. Now that doesn’t sound so bad, does it?

HT: Foosion

Marcus Nunes directed me to a very interesting post by Roger Farmer (written right after the Brexit vote.) Farmer suggests that the Bank of England needs to do whatever it takes to prevent uncertainty from depressing aggregate demand. Indeed it should consider buying shares in an index fund, if necessary.  He then provides a comment from Thomas Hutcheson:

“This is fine so far as it goes, but we should deal as well with the policy response of the ECB and the Fed, as well. Whatever long term damage may occur from slightly less free trade (including investment to trade) cannot be prevented by central banks, but they can prevent the damage that comes from uncertainty about the future course of NGDP. It is expectations about that they should seek to stabilize.”

Farmer replies to Hutcheson as follows:

I am in broad agreement with the proposal to stabilize expectations of future NGDP growth and, in the simple models that guide my thinking, stabilizing asset price growth and stabilizing expectations of NGDP growth amount to the same thing. The question is: how to achieve that goal?

If central banks simply substitute NGDP targeting for inflation targeting, and if they continue to try to achieve their objective by adjusting short term interest rates, not much will have been achieved. Scott Sumner has proposed instead, that central banks should trade NGDP futures. Robert Shiller goes further and advocates that national governments finance their borrowing requirements by issuing equity-like instruments that pay a trillionth of GDP: Shiller calls these ‘trills‘. I wholeheartedly endorse both of these proposals. Creating a market for nominal GDP futures, and actively trading trills for Tbills would have much the same effect as stabilizing asset price growth.

Needless to say, I’m very pleased to see that Farmer is receptive to NGDP futures targeting.  We both have a longstanding interest in the relationship between asset prices and macroeconomic stability, which perhaps puts us a bit on the fringe of the mainstream.  But Farmer is much better known than I am (he teaches at UCLA) so any support from him is very welcome.

I did find the next paragraph a bit confusing:

I differ from Scott in one important respect. Whereas Scott sees NGDP targeting as a substitute for inflation targeting, for me, it is a complement. Central banks should set interest rates to target inflation, and they should set the growth rate of some other object, be it asset prices, NGDP futures, or the price path for trills, to target the unemployment rate.

I’d need to know more, but here’s my initial reaction.  Normally economists think that you need two independent tools to hit two distinct policy targets.  Farmer would probably say that his plan contemplates two tools (interest rates and NGDP futures.)  But I see basically only one tool.  The Fed would presumably use standard monetary policies (open market operations, interest on reserves, etc.) to affect both interest rates and NGDP futures.  Can slightly different monetary tools have two independent impacts?  Buying T-bonds and stocks, for instance?  Maybe, but I’m an old school monetarist in the sense that I believe it’s the liability side of the balance sheet that really matters, not the asset side.  So unless I’m missing something, I’m skeptical of Farmer’s claim.

I should add that I am assuming this is a sort of business cycle argument.  I take it as a given that monetary policy doesn’t affect the long run trend rate of unemployment, and hence you cannot choose independent long run targets for inflation and unemployment.  (At least without other tools, beyonds monetary policy.)

PS.  Off topic, I greatly enjoyed Tyler Cowen’s recent interview at the IEA.  There was virtually nothing with which I disagree.  That’s not to say I could make the same arguments; he’s a much better social scientist than I am.  I just point this out because I have a habit of mostly responding to posts I disagree with, and so if you want to see where our views agree, that interview is a great example.  (Covers the Great Stagnation, Brexit, negative rates, education, a bit on Trump, and a few other topics.)

PPS.  Zachary David responded to my recent post on NGDP futures:

In true Sumnerian fashion, he begins with an off-hand remark about how I ignored/didn’t read his proposal. Any long time follower of his, like me, knows that this is Sumner’s standard opening move for responding to all criticisms of NGDP targeting. I’ve read it all; it’s still goofy. (though not as goofy as the time he called Arctic Monkeys a one-hit wonder)

I was giving him the benefit of the doubt.  If he actually read that paper, and then still wrote his deeply misleading post, then that’s much worse.

Let’s start here:

He wonders why NGDP futures would be such a good idea, given that the private sector hasn’t already created such a market. Perhaps that’s because the private sector is not legally allowed to do monetary policy.

Oof. This is embarrassing. Sumner attempts to imply that we haven’t seen a private sector futures contract linked to NGDP because it would necessarily “do monetary policy” which the private sector cannot. It’s a gross non sequitur and completely ignores my point. In the main piece, you’ll see that there are no fundamental or market structure issues preventing the creation of an NGDP futures contract. I use the unpopularity of the former unemployment-linked contracts as an analogous example of why his market might have problems gaining traction. Dressing up a futures contract as “monetary policy” does not make it any less of a futures contract.

The only thing embarrassing is David’s failure to understand what I wrote.  I never said an NGDP futures market would necessarily do monetary policy, I said that would be the logical motivation for creating such a contract.  If the private sector is not doing monetary policy, why would it want to create such a market?  Yes, there are no barriers to creating such a market.  Indeed I created one.  So what’s the point?

As far as not gaining traction, why would I care?  If monetary policy stabilizes the price of NGDP futures, it really doesn’t matter whether there is any trading at all.  I explained all this in the paper that he insists he read, but somehow didn’t understand.  If David’s too lazy to read the entire paper, he can try the section entitled “What if No One Trades”, which begins on page 18 and goes all the way through page 21.  Don’t you think it’s a bit silly to read that entire section, and then whine that Sumner doesn’t realize that no one might trade his contracts?

The rest of his response is more of the same.  He quotes me, and then misrepresents what I said.  Perhaps the funniest example is where he claims I was advocating a gold price peg:

. . . did an economist really just extol the virtues of gold standard pegging?

Um, no.  Why do you ask?

HT:  Dilip,  James Elizondo

Many commenters have asked me for my views on a recent WaPo article by Larry Summers.  (And by the way, doesn’t anyone proofread at WaPo? They have the wrong inflation expectations graph, showing the Michigan survey instead of TIPS spreads.)

Here’s how Summers begins:

As the Federal Reserve meets today and tomorrow, I am increasingly convinced that while they have been making reasonable tactical judgement, their current strategy is ill adapted to the realities of the moment.

Summers is known for favoring discretion over rules, but this is exactly why the Fed needs to shift to a policy rule.  In recently years I’ve made much the same argument, the problem is not the current stance of policy, it’s the entire policy regime, which has no mechanism to prevent a repeat of 2008.

Japan’s essential macroeconomic problem is no longer lack out output growth. Unemployment is low. Relative to its shrinking labor force, output growth is adequate by contemporary standards. Japan’s problem is that it seems incapable of achieving 2 percent inflation. This makes it much harder to deal with debt problems and leaves the Japanese with little spare powder if a recession comes.

I’ve been saying the same thing, for quite some time.

Any consideration of macro policy has to begin with the fact that the economy is now seven years into recovery and the next recession is on at least the far horizon. While recession certainly does not appear imminent, the annual probability of recession for an economy that is not in the early stage of recovery is at least 20 percent. The fact that underlying growth is now only 2 percent, that the rest of the world has serious problems, and that the U.S. has an unusual degree of political uncertainty all tilt toward greater pessimism. With at least some perceived possibility that a demagogue will be elected as president or that policy will lurch left, I would guess that from here the annual probability of recession is 25 percent to 30 percent.

This seems to me the only way to interpret the yield curve. Markets anticipate only about .65 percentage point of increase in short rates over the next three years. Whereas Fed officials’ projections suggest that rates will normalize at 3.3 percent, the market thinks that even five years from now they will be about 1.25 percent.

Summers agrees with us market monetarists; market predictions are more plausible than Fed predictions. Perhaps Summers learned that the wisdom of the crowd applies to interest rate forecasts, from a painful episode as Harvard President.

Despite an impressive resume that includes stints as Treasury Secretary and chief economist of the World Bank, there is a very good reason Summers shouldn’t be in charge of monetary policy: He seems to have trouble with interest rates.

During the financial crisis, Harvard lost nearly $1 billion because of some unusual and ill-judged interest rate swaps that Summers implemented in the early 2000s during his troubled tenure as the university’s president.

Back to the WaPo article:

What does this mean? First, it implies that if the Fed is serious — as it should be – about having a symmetric2 percent inflation target, then its near term target should be in excess of 2 percent. Prior to the next recession — which will presumably be deflationary — the Fed should want inflation to be above its long term target.

Just the opposite.  The Fed should aim for below 2% inflation before the next recession, and above 2% inflation during the next recession.  That’s not just a good idea, it’s the law.  (I.e. an implication of the dual mandate is that inflation should be countercyclical.) In Summers’ defense, he may argue that it’s reasonable to assume that recessions are caused by bad monetary policy, i.e. by fluctuations in NGDP.  If that is the case, then inflation will end up being procyclical.  And if inflation is procyclical, then to hit the 2% inflation target on average, you’d need inflation above 2% during booms and below 2% during recessions.  But again, why not stabilize NGDP growth instead, which would be more consistent with the Fed’s mandate to produce countercyclical inflation?

Those who think that raising rates somehow helps the economy prepare to be counter-cyclical are confused. Given lags, raising rates now would increase the chances of recession, along with the likely severity. Raising inflation and inflation expectations best prevents and alleviates recession.

Summers is right to criticize those who believe that raising rates gives the Fed less more (conventional) ammo to fight the next recession, but his explanation is inadequate. It would give the Fed less ammo even if it did not raise the risk of recession. The real problem is that raising the fed funds target right now would lower the nominal Wicksellian equilibrium rate, and it is the nominal equilibrium rate that determines how much ability the Fed has to ease policy by conventional means (interest rate cuts.)

Experience has proven that Yellen was correct to be skeptical of the idea very low inflation rates would improve productivity.  And it is plausible that the error in price indices has increased with the introduction of new categories of innovative and often free products.

This means that if a two percent inflation target reflected a proper balance when it first came into vogue decades ago, a higher target is probably appropriate today. This is another reason to allow inflation to rise above 2 percent.

I do believe that high inflation reduces productivity, but Summers is right that there is virtually no difference in productivity between 2% and 3% inflation.  It’s not even clear which one would lead to higher productivity.

Summers concludes:

Over the last 12 months nominal GDP has risen at a rate of only 3.3 percent. We hardly seem in danger of demand running away.  Today we learned that Germany has followed Japan into negative 10 year rates. We are only one recession away from joining the club. The Fed should be clear now that its priority is not preventing a small step up in inflation, which in fact should be welcomed, or returning interest rates to what would have been normal to a world gone by.

Instead the Fed should focus on assuring adequate growth in both real and nominal incomes going forward.  (emphasis added)

I agree, except for the three words highlighted.  The Fed should focus like a laser on NGDP and ignore RGDP, in the hope that stable growth in NGDP will result in more stable growth in RGDP.  A subtle distinction, but an important one.

PS.  I’m encouraging my daughter to change her last name from Sumner to Summer, when she goes away to college.