Blogger Bernanke's Abundance of Caution
Ben Bernanke, a think-tanker who has for some reason rapidly moved into the top rank of economics bloggers, has written a post that seems destined to be influential. It’s about various proposals to reform monetary policy.
He's open-minded about the proposals: He says there's nothing “magical” about the 2 percent inflation target that the Fed formally adopted in 2012. But he offers reasons for caution about some alternative approaches. When it comes to proposals that the Fed target the level of nominal spending rather than the rate of inflation, his caution may be excessive.
In targeting the level of nominal spending, the Fed would aim to ensure that total dollars spent throughout the economy grow at (say) 5 percent a year. In a year where the economy grew by 3 percent in real terms and the target was hit, inflation would run at 2 percent. The Fed would also commit to making up for undershooting that 5 percent target in one year by overshooting it the next, and vice-versa.
One advantage of this approach over inflation targeting is that it would allow the inflation rate to shift when warranted. Take the case of a negative supply shock, such as an oil embargo. A Fed that strictly targeted inflation would have to tighten monetary policy to keep inflation from rising -- but at the cost of causing the real economy, already hit by that shock, to contract further. A Fed with a 5 percent nominal-spending target would instead allow inflation to rise. It wouldn't even need to know anything about the supply shock to know what to do.
Bernanke suggests that this policy might not be compatible, or at least not compatible in any easily understood way, with the Fed’s statutory mandates to keep inflation and unemployment low. And it could threaten the Fed’s hard-won achievement of stabilizing inflation and expectations about inflation.
The economist Scott Sumner points out that a nominal-spending target is compatible with the mandate, because the Fed would target a single variable that incorporates both inflation and real output, which correlates with employment.
It's certainly true that we would not want to go back to the high and unpredictable inflation of the late 1970s. The market knows not to expect the economy to suffer either high inflation or deflation next year. At the same time, inflation isn't totally stable and predictable now. It dropped quickly, and we even saw deflation, in 2008-2009.
Sumner is among those who have argued that stabilizing the path of nominal spending is more important than stabilizing prices. But there’s also an argument that shifting to a nominal-spending target could help stabilize price movements. This may seem counterintuitive: How could targeting something other than inflation do more than targeting inflation to keep prices on track?
Part of the answer is that correcting for past failures to hit the target makes the long run more predictable. Also, a nominal-spending target can be set at a level that implies whatever average inflation rate is desired, so long as we have a rough expectation of how fast the economy will grow in real terms, as Columbia University economics professor Michael Woodford pointed out in a 2013 paper. If the Fed expects real annual growth of 2.5 percent on average, and wants 2 percent inflation on average, then it can set a nominal-spending target of 4.5 percent.
Nominal-spending targeting can be seen, in fact, as a kind of flexible inflation targeting -- with the flexibility constrained by a rule. The Fed already has a flexible rather than a rigid 2 percent inflation target. If it were to say that its flexibility would take the form of letting the inflation rate in any year move up and down around the 2 percent average, with the movement depending on productivity growth, it would effectively be targeting the level of nominal spending. Indeed, during the Great Moderation of the 1980s, the Fed kept nominal spending on a stable path for many years without ever saying it was targeting it. That was the very period during which inflation expectations became better anchored, and the Fed was seen as fairly successful at fulfilling its mandate.
None of these considerations clinch the case for targeting the level of nominal spending. But they suggest that if the Fed decided to move in this direction, it could address this novice blogger's worries by doing so in a cautious and incremental way.
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