That’s “former central bankers”

A few days ago I posted a discussion of the apparent conflict between a well-publicized Fed study of the Taylor Rule’s policy implications, and the traditional Keynesian view of the SRAS.  The study claimed that we needed Fed policy to be expansionary enough to reduce interest rates by 5%.  The clear implication (since nominal rates are near zero) was that we needed at least 5% inflation expectations.  I claimed this made no sense, as the SRAS is generally assumed to be fairly flat in a deep recession, and that with very high unemployment, NGDP increases in the 5-8% range would almost certainly be expected to consist mostly of real output gains, with only mild inflation.

I also noted that Krugman and Mankiw linked to the Fed study, but I clearly indicated that there was no sign they endorsed the findings.  Since then, a commenter named Charlie has sent me a Krugman post that seems (to me at least) to clearly suggest that he does endorse the implicit message in the Fed study, which is that in the current environment monetary policy could only work by creating high inflation expectations.  See what you think:

Greg Mankiw says yes. Since that was the answer I arrived at for Japan more than a decade ago, I have to say that it makes sense in principle.

But here’s why it won’t work now, at least not yet: we’re talking about making a credible commitment to fairly high inflation over the medium term, yet you still have distinguished central bankers appalled at the Fed’s 2 percent inflation target.

I simply cannot see any way of interpreting the second paragraph other than that by “fairly high inflation” Krugman means at least 5% or more.  You are free to disagree, but if Krugman meant simply 2-3% inflation it would be a very odd way of making his point.  First, because that sort of inflation is normal for the US, and second, because the term “yet” suggests that a 2% target would fall far short of what is needed.

So let me repeat my assertion.  I think this represents a fundamental error.  The 5% number only makes sense in a backward-looking Taylor rule model.  But what if the Fed is targeting the forecast?  What if the Fed policy is expansionary enough to produce 5-8% NGDP growth?  You tell me (Keynesian readers)—what sort of expected inflation would you expect from that sort of nominal GDP growth in a deep recession?  I say that the traditional Keynesian answer is 2-3% inflation at most, and the rest would be RGDP growth.  This is one of the few times when I think the traditional Keynesian answer is exactly right.  [In IS-LM terms I believe this can be explained by the fact that a monetary policy expansionary enough to produce rapid NGDP growth will also shift the IS curve.]

BTW, check out how many “central bankers” in the article that Krugman links to actually support 2% inflation, and how many oppose 2% inflation.  I count two in favor, zero against.  Each day the objections to monetary stimulus grow less and less persuasive.

[P.S.  Why do I keep linking to Krugman?  Because although there are many fine Keynesian bloggers; his grasp of the theoretical issues seems way ahead of almost anyone else (Keynesian or non-Keynesian.)  And he holds the currently fashionable view that monetary policy ran out of ammunition last year.  I seem to recall that in wartime soldiers were told to shoot at the opposing general, in the hope that if he fell off his horse the soldiers would lose hope, and run for the hills.  Old-style Keynesians are constantly bombarded with criticism from “fresh water economists” about how their model is hopelessly out of date.  I am sure they take solace from the fact that someone as smart as Krugman defends their views.  If I can undercut Krugman’s central argument, then I’m hoping that all the other old-style Keynesians will abandon their blogs and run for the hills.]



5 Responses to “That’s “former central bankers””

  1. Gravatar of Lord Lord
    19. May 2009 at 14:19

    Volcker certainly sounds opposed, 2% leads to 3% leads to 4%. Others who speak of hyperinflation do as well. And Krugman emphasizes conventional short term monetary policy which just demonstrates something further is needed but what and how effective it may be and what problems it may engender such as reduced control by the Fed in the future are open for discussion. Isn’t it already believed the Fed is targeting 2% inflation, even if the market may not believe the Fed is willing to do what is necessary to maintain it?

  2. Gravatar of travis travis
    19. May 2009 at 15:22

    Great job getting to the essence of the issue of the effectiveness of monetary policy. Krugman and other Keynesians will eventually be forced to face the contradictions within their position.

    I really admired the pre-NYT Krugman. Unfortunately now he just seems to talk his policy book and ignores everything he said previously about the effectiveness of monetary policy. Sad.

  3. Gravatar of ssumner ssumner
    19. May 2009 at 16:50

    Lord, You missed my pathetic attempt at humor in the post title. Bernanke and Kohn favor 2%, Volcker is not a central banker, so I don’t see how his opposition is relevant.

    There are two questions. Is the Fed willing to try to create inflation expectations? If so, will it succeed? The Fed hints at a 2% target, but there is no commitment. If they fall short this year (and they will) will they shoot for 3% next year? Bernanke once said that’s what Japan needed to do, but almost no one believes the Fed will try to catch up. Level targeting is the test of whether they are serious. The markets see that they expect to fail (even according to internal Fed forecasts) and see no actions to try to catch up. They draw the obvious conclusions. When they started paying interest on reserves in October their explanation (not mine, theirs) was they hoped the impact of the policy would be contractionary. That policy is still in effect. The markets are not dumb.

    Thanks travis, You might like the newest post I just listed.

  4. Gravatar of TheMoneyIllusion » Be careful what you wish for TheMoneyIllusion » Be careful what you wish for
    8. June 2009 at 03:23

    […] post is related to an earlier post criticizing Krugman’s argument that in order to be effective monetary stimulus would have to […]

  5. Gravatar of TheMoneyIllusion » Dr. Krugman and Mr. Keynes TheMoneyIllusion » Dr. Krugman and Mr. Keynes
    20. July 2009 at 04:16

    […] to he hints that the inflation target would need to be higher than 2% to produce robust growth.  That is not accurate.  Because the SRAS is relatively flat when AD has fallen sharply, right now an expected inflation […]

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