Six reasons to oppose inflation targeting

Tyler Cowen and James Surowiecki have recently discussed why it is difficult for the Fed to set a higher inflation target.  They’re right.  All you need to do is read conservative press accounts of the recent Fed statement, which figuratively roll their eyes at the suggestion that we might need a little more inflation.  “Imagine that!  The Fed thinks we need more inflation.  Don’t they know inflation is a problem?”

Of course this is frustrating to macroeconomists, because if we are targeting inflation at say 2%, then it stands to reason that approximately one half of the time inflation will be too low, and one half of the time it will be too high.

But the articles that mock the Fed are not written to be read by macroeconomists, they’re to be read by the general public.  And the public does believe that inflation is a problem, for several very good reasons.  First, for any given nominal income, higher inflation will tend to hurt an individual worker.  And second, most of the major increases in inflation have been associated with bad times.  Think about 1974 or 1979, or the first half of 2008.  Of course all those were associated with adverse supply shocks.  You have to go back to the second half of the 1960s to find a major increase in inflation that was associated with good times.

On the other hand, if AD rises briskly and brings inflation from below normal back up to normal, most people feel better off.  So when the Fed says it would like to see higher inflation, what it is really saying is that it would like to see higher AD, which as a side effect will raise inflation somewhat.  For any given level of AD, higher inflation would be a bad thing, as it would represent an adverse supply shock.  So why not just call for higher AD?  We know that an increase in AD raises both prices and output, so it seems like what they really want is more NGDP, not higher prices.  Higher NGDP is definitely needed in a demand-side recession, whereas higher inflation might or might not be a good thing.

Consider the following 7 questions:

1.  Which target best measures what the Fed is directly trying to influence, NGDP or inflation?

Answer:  NGDP targeting.  For a given level of NGDP, higher inflation would actually be harmful.

2.  Which policy goal sounds better to the public, higher inflation or higher nominal NGDP?

Answer:  Hmmm, would you rather tell the public you are trying to boost their incomes back to prosperity levels, or that you are trying to raise their cost of living?

3.  Which policy is more consistent with the Fed’s dual mandate?

Answer:  NGDP targeting

4.  Which policy doesn’t force government bureaucrats to make high subjective estimates of quality changes in products?

Answer:  NGDP targeting

5.  Which policy is most like to prevent bubbles; NGDP or inflation targeting?

Answer:  NGDP targeting, which calls for lower inflation during booms.

6.  Which target best avoids liquidity traps, NGDP or inflation targeting?

Answer:  NGDP targeting, as 1% deflation may or may not result in a liquidity trap, depending on the trend real GDP growth rate.

7.  Which target is preferred by the Fed and most macroeconomists?

Answer:  Inflation targeting.

The public instinctively feels the Fed should be targeting NGDP.  And if they were, inflation really would be bad.  Always.  The public’s not stupid; they’re one step ahead of macroeconomic elite!  🙂

Update 9/27/10:  David Beckworth pointed out several advantages of NGDP targeting that I forgot to mention.  It is easier to implement than a Taylor Rule, and it has been advocated by a number of respected macroeconomists, both center-left and center-right.



20 Responses to “Six reasons to oppose inflation targeting”

  1. Gravatar of Benjamin Cole Benjamin Cole
    26. September 2010 at 10:33

    Some ammo for monetary bulls: We are overestimating inflation.

    “July 09, 2010

    How close to deflation are we? Perhaps just a little closer than you thought
    Since last October, the consumer price index (CPI) has gone up an annualized 0.7 percent. On an ex-food and energy basis, the number is a little lower, at 0.5 percent. And the Cleveland Fed’s trimmed-mean and median CPIs, at 0.7 percent and 0.2 percent, respectively, also put the recent trend in consumer prices in pretty low territory….

    And this is before we take into account any potential mismeasurement, or “bias,” in the construction of the CPI….

    How big is the CPI’s bias? Well, in 1996, the Social Security Administration commissioned a study on the accuracy of the CPI as a measure of the cost of living. This so-called “Boskin Commission Report” said the CPI was overstated by about 1.1 percentage points per year. The commission identified several sources of potential bias, but about half of the 1.1 percentage points resulted from new products and quality changes that were slow or otherwise imperfectly introduced into the price statistic.

    Now, in an article (available to all in its working paper version) appearing in the latest issue of the American Economic Review, Christian Broda and David Weinstein say the earlier estimates of the new goods/quality bias may be a bit understated. The authors examine prices from the AC Nielsen Homescan database and conclude that between 1996 and 2003, new and improved goods biased the CPI, on average, by about 0.8 percentage points per year. If this estimate is accurate, consumer price increases since last October would actually be around zero, or even slightly negative, once we account for the mismeasurement of the CPI caused by new and improved goods….

    Boskin has cred on the right-wing.

    Monetary bulls need to emphasize that those ossified federal bureaucrats using their slide-rules and measuring the price of horseshoes, are overestimating inflation.

    Right now we are at at zero and falling, I would say. That’s the story to get out–gives room to maneuver for monetary bulls.

    Also, keep on point on Japan–they have zero inflation, and are on their way to becoming a backwater nation.

  2. Gravatar of Morgan Warstler Morgan Warstler
    26. September 2010 at 10:40

    Let’s just be 100% clear:

    You can target NGDP until inflation goes over 2%. Then the goal is to reduce inflation under 2%.

    Ok go!

  3. Gravatar of StatsGuy StatsGuy
    26. September 2010 at 17:13

    It seems your post should read “7 reasons to favor NGDP targeting.”

    The 7th reason is obviously the strongest. 🙂

  4. Gravatar of greg ransom greg ransom
    26. September 2010 at 19:30

    I’m in.

    “5.  Which policy is most like to prevent bubbles; NGDP or inflation targeting?

    Answer:  NGDP targeting, which calls for lower inflation during booms.”

  5. Gravatar of Greg Ransom Greg Ransom
    26. September 2010 at 22:18

    “It is not so well known that [Keynes’s and my own Hayek-inspired move from thinking in terms of price-levels and the rate of interest to thinking in terms of inputs and outputs] is matched by a movement from Hayek to Harrod. I once asked Harrod what had put him on to the construction of his so-call ‘dynamic’ theory [i.e. Harrod’s early version of modern capital theory]; he said, to my surprise, that it was thinking about Hayek.” — John Hicks

    You’re about halfway there, Scott.

  6. Gravatar of Bill Woolsey Bill Woolsey
    27. September 2010 at 02:49

    Great post!

    All you need to add is “growth path” and it would be perfect.

    Of course “inflation” is a growth rate. NGDP (or final sales of domestic product,) is a level, whose growth path or growth rate might be targeted.

  7. Gravatar of More Inflation Yes, Inflation Targeting No! More Inflation Yes, Inflation Targeting No!
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  8. Gravatar of Keith Keith
    27. September 2010 at 05:19


    Q1: Precisely what NGDP do you think should be targeted? By that, I mean over what timeframe: 6 mos, 1 yr, 2 yr?

    The timeframe over which NGDP is targeted would affect the stability of the economy. But that would be true of inflation targeting too.

    Q2: Should the rule be fixed and known, as in a law, or an unstated rule?

  9. Gravatar of jj jj
    27. September 2010 at 06:00

    I think understanding and accepting NGDP targeting is too big a leap for most people, for now. But inflation, which is accepted (though not really understood), has an image problem: the public thinks that the less of it, the better.

    Is there a way to reframe the comfortable concept of inflation in a more helpful way? I think the public would quickly accept that “predictable and consistent inflation” is better than merely low inflation. The Fed needs to openly make, and keep, a bargain with the public over inflation.

    The CPI is a far-from-ideal target, but it’s what people actually see. Income is also an intuitive concept, but it’s more open to conservative attack: “So you want to guarantee income, now?”

    Is that why you talk about GDP instead of GNI?

  10. Gravatar of scott sumner scott sumner
    27. September 2010 at 06:45

    Benjamin, Those are good points. The only reason I think we’ll avoid the Japanese scenario is that for any given inflation rate, we have higher NGDP growth. Even so, it is becoming too close for comfort.

    Morgan, That direct order should be sent to Bernanke, not me.

    Statsguy, Touche. (And I’m the one that gets accused of being snarky.)

    Thanks Greg, Unfortunately I fear I will die before completing the other one half of the journey.

    Thanks Bill.

    BTW, I added a brief update that links to a David Beckworth post with some more arguments.

    Keith, Those are very good questions. Initially I thought one year was best, but now I am leaning more toward two years (this assumes level targeting, i.e targeting an pre-determined growth trajectory, where catch up for previous mistakes occurs.) I don’t think it need be a law, as long as it is a very explicit central bank target, not just some vague target like we have now with inflation. But a law would be best.

    jj, I think it is too big a shift to make in the cycle, another commenter made that point in a different post recently. I am trying to educate people so that more consideration will be given to NGDP in future cycles. I think it is a long process, as people must become comfortable with the idea.

    I really can’t think of any way to make higher inflation sound appealing to the public, but I’m open to suggestions.

  11. Gravatar of NGDP Targeting: A Response to Sumner and Beckworth «  Modeled Behavior NGDP Targeting: A Response to Sumner and Beckworth «  Modeled Behavior
    27. September 2010 at 07:57

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  12. Gravatar of Morgan Warstler Morgan Warstler
    27. September 2010 at 11:53

    Scott, do you get my point?

    The public isn’t going to stand for “inflation is 4%, 5% – but pay no mind, because we’re still below the NGDP target.”

    So whats possible in your theory, when we ONLY target when inflation is under 2%?

    That’s my question??

  13. Gravatar of Howard Howard
    27. September 2010 at 11:54


    Any specific article or book by Hicks or Harrod which is worth a read?

  14. Gravatar of scott sumner scott sumner
    27. September 2010 at 17:35

    Morgan, You said;

    “The public isn’t going to stand for “inflation is 4%, 5% – but pay no mind, because we’re still below the NGDP target.””

    They stood for it in July 2007 to July 2008, and they’ll stand for it again.

    I oppose inflation targets, there’s no need to pay any attention to inflation.

  15. Gravatar of Jim Jim
    28. September 2010 at 16:35

    That’s a terrible idea. Do you not believe in money neutrality? Exogenous growth?

    A better idea, which would argue for more or less the same high inflation now, but which wouldn’t imply excessively soft monetary policy during supply shocks, would be price level targetting. You should read Carl Walsh’s latest paper (given to the ACE ’10)–especially part 6.

    And (shock!) you should perhaps look at the actual outcomes of inflation targetting countries during this most recent shock. In sum, no worse, no better. But the fiscal positions of almost all countries with their own inflation-targetting central banks had better fiscal positions before the crisis, in part due to the tighter monetary policy they had run during the Great Boom.

    When the US reaches its fiscal limit, and Canada, Australia, and NZ don’t, it will be in no small part due to inflation targetting.

  16. Gravatar of Scott Sumner Scott Sumner
    29. September 2010 at 12:36

    Jim, Sorry, but I don’t see how your comment relates to my post. How does this show inflation targeting is better than NGDP targeting?

    The ECB and Japan also inflation target.

    Money is neutral in the long run, but not short run. But I don’t see how that has anything to do with this issue.

  17. Gravatar of Jim Jim
    29. September 2010 at 16:48

    Scott, I said “almost all countries with their own inflation-targetting central banks”–that excludes Euroland (where fiscal incontinence of any member country does not invite the same monetary response that would occur were they to have their own independent central banks). I disagree wholly with the institutional setup of Euroland.

    Also, Japan does not inflation target:

    Your idea would be especially bad for small open economies. Australia’s NGDP is currently growing at 10% (June Quarter), although CPI is within the target range of 2-3%. This is because the GDP deflator is influenced by export prices–which in Australia’s case are growing quickly due to Chinese demand for resources. Forecasting monetary policy in this case would be akin to forecasting iron ore and coal prices. Do you know anyone that’s very good at this?

    And what if productivity growth is variable? Or what if changes in it are unforcastable? This would imply that it would be very difficult to make good predictions about consumer prices (to the extent that they contribute to GDP prices). I’m sure people would really love that.

    So what you’re calling for is a world in which both monetary policy and consumer prices are almost impossible to forecast. Goody.

  18. Gravatar of ssumner ssumner
    30. September 2010 at 06:04

    Jim, Japan has a zero inflation target, I call that inflation targeting.

    I did not advocate NGDP targeting for small open economies, I advocated it for the US.

    I also advocated level targeting, not growth rate targeting, so the Australian data doesn’t necessarily imply anything.

    I have been very complimentary of the Australian central bank in this blog.

    You said;

    “And what if productivity growth is variable? Or what if changes in it are unforcastable? This would imply that it would be very difficult to make good predictions about consumer prices (to the extent that they contribute to GDP prices). I’m sure people would really love that.”

    I favor targeting the forecast. People care about NGDP growth, not inflation. Here’s two recent examples from the US:

    1. In the high tech boom, wage growth and NGDP growth sped up, inflation didn’t. Workers care about NGDP, not inflation.

    2. In 2007-08 Inflation sped up (as oil prices soared) but NGDP growth and wage growth remained low. Workers care about NGDP growth, not inflation.

    Economists made a big mistake putting inflation in all their macro models (at least in a large diversified economy like the US.) What matters for macro stability is NGDP growth, not inflation. What matters for wage growth is NGDP growth, not inflation. What matters for a liquidity trap forming is NGDP grwoth, not inflation. If inflation mattered the Fed should have raised rates sharply in July 2008, when oil prices forced inflation up to around 5%. How would that have worked out?

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