Federal Reserve

Inflation Should Rise in Recessions

Lawrence Summers supports a sensible shift in monetary policy. Here's a question.

Nothing is written in stone.

Photographer: Brendan Smialowski/Bloomberg

Those of us who favor a new monetary regime, in which the Fed would stop setting a target level for inflation and start targeting nominal spending instead, can rejoice at having apparently made an influential convert: Lawrence Summers.

Summers -- who was an architect of economic policy in the Clinton and Obama administrations -- announced his shift in thinking in a recent op-ed, and says he will explain his reasoning in more detail soon. Most of the piece is devoted to arguing that the Federal Reserve has erred in raising interest rates, even if one accepts the wisdom of inflation targeting.

Summers makes a powerful case. But it’s worth lingering over one argument within it. He believes that if the Fed wishes to see inflation average 2 percent a year, it should shoot for above 2 percent inflation during economic expansions. It should “modestly raise target inflation, perhaps 2.3 or even 2.5 percent inflation, during a boom with the expectation that inflation will decline during the next recession.” His explicit assumption is that “when recession comes, inflation declines.”

That is indeed generally the case. But it would not be the case under a Fed that was effectively pursuing the nominal-spending target Summers now seems to favor.

Nominal spending is the total amount of dollars spent throughout the economy. Its growth rate is equal to the sum of both the inflation rate and the real economic growth rate. An economy with 2 percent inflation and 2 percent real growth would have 4 percent growth in nominal spending.

If inflation fell during a recession, it would mean that the Fed had failed to hit its nominal-spending target.

Let’s say the Fed committed to setting interest rates so as to keep nominal spending growing at that 4 percent clip. If real growth slowed to 0 percent, inflation would have to rise to 4 percent for that target to be hit.

In a world where inflation falls during recessions, as Summers assumes it will, inflation contributes to the ups and downs of the business cycle: It feeds the economy during booms and then goes away during busts. Under nominal-spending targeting, inflation would be countercyclical.

Or we can turn the lens the other way. If inflation falls during recessions, as Summers assumes it will, it means that nominal spending rises more rapidly during an expansion than during a recession. (Since both real economic growth and inflation are higher in the boom, their sum has to be higher, too.) And if nominal spending isn’t growing at a steady rate, either the central bank isn’t trying to stabilize its growth or it’s not succeeding in hitting its target.

Using a nominal-spending target instead of an inflation target would allow monetary policy to do a better job of handling supply shocks, in which the supply of commodities or services suddenly increases or decreases.

If a negative supply shock reduces real economic growth, the central banker who targets inflation will also be tempted to aim for lower nominal spending, too. He might raise interest rates to keep inflation from rising above 2 percent when real growth sank to 0 percent. But that would mean further weakening the economy at a low point.

A positive supply shock -- such as a technological change that improved productivity -- would lead inflation-targeting central bankers to make the opposite error. If economic growth rose to 3 percent, they would cut interest rates to keep inflation from falling -- providing more juice for an economy that doesn’t need it.

Under a nominal spending target, then, inflation would tend to move up and down in a way that dampened the business cycle. That is one reason I favor the policy.

But it also creates a political difficulty during downturns. For most people, combining a rise in inflation and a decline in real economic growth would be adding injury to injury -- even if the Fed wasn’t responsible for the decline in real growth, and even if trying to keep inflation down during a negative supply shock would make growth even lower.

It’s a thorny problem. But Summers is an extremely smart man, and perhaps he can find a way out of it.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

    To contact the author of this story:
    Ramesh Ponnuru at rponnuru@bloomberg.net

    To contact the editor responsible for this story:
    Katy Roberts at kroberts29@bloomberg.net

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