Thursday, September 15, 2011

Changing the Rules?

In a recent speech, Chicago Fed President Charles Evans argued that the Fed has been neglecting the "maximum employment" part of its mandate "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." Evans explains:
Suppose we faced a very different economic environment: Imagine that inflation was running at 5% against our inflation objective of 2%. Is there a doubt that any central banker worth their salt would be reacting strongly to fight this high inflation rate? No, there isn’t any doubt. They would be acting as if their hair was on fire. We should be similarly energized about improving conditions in the labor market.

In the United States, the Federal Reserve Act charges us with maintaining monetary and financial conditions that support maximum employment and price stability. This is referred to as the Fed’s dual mandate and it has the force of law behind it.

The most reasonable interpretation of our maximum employment objective is an unemployment rate near its natural rate, and a fairly conservative estimate of that natural rate is 6%. So, when unemployment stands at 9%, we’re missing on our employment mandate by 3 full percentage points. That’s just as bad as 5% inflation versus a 2% target. So, if 5% inflation would have our hair on fire, so should 9% unemployment.
At his blog, Stephen Williamson offers a critique of the speech.  Among his arguments:
Evans is forgetting the lessons of the 1970s. What Evans is proposing is a change in the policy rule - a change in how the state of the economy maps into actions by the Fed. What economists understand today that they did not in 1975, is that commitment by the Fed to a policy rule is critical for its success in fulfilling its mandate. Once the public understands that the Fed intends to exploit a short-run Phillips curve relationship (and the problem is worse if the short-run inflation/unemployment tradeoff in fact does not exist), then all bets are off. High inflation can become well-entrenched and we have to go through an episode like the policy-induced "Volcker recession," followed by a long period where the Fed re-establishes its credibility. 
Although the wording of the Federal Reserve Act requires the Fed to care about both inflation and unemployment, as Williamson notes, its practice has evolved towards a de facto inflation targeting rule with an objective similar to the European Central Bank's "below, but close to 2%".  This is evinced by all the mentions of the Fed's "comfort zone" as well as the "longer run" projections of 1.5-2% inflation from Fed board members and regional bank presidents.  In terms of economic theory, it can be justified by the result, in some models, of "divine coincidence" - that policies which stabilize inflation also stabilize output.

If the Fed heeded Evans' argument, it would be more willing to risk breaking its inflation target rule to reduce unemployment.  In economic theory, one of the main points benefits of having a rule is that it lends "credibility" to monetary policy and "anchors" expectations (this speech by Charles Plosser is a nice intuitive exposition of the "time consistency" logic underlying this argument).  But that only works if the central bank actually follows its rule.  Hence Williamson's concern.

Inflation targeting is relatively new - New Zealand was the first to adopt the practice in 1989, and it has since been implemented by the UK, Canada, and the European Central Bank, among others.  Most of the countries that have adopted inflation targets have set them in the vicinity of 2%.

While there are good reasons in economic theory for having monetary policy rules, the past few years have raised questions over whether a 2% inflation target is the right rule.  There are several alternative rules that might have performed better in the wake of the financial crisis:
  1. Inflation targeting with a higher target would reduce the risk of hitting the "zero lower bound" on short-term interest rates.
  2. Price level targeting would require higher inflation to make up for periods of too-low inflation.  
  3. Nominal GDP targeting is a re-incarnation of Milton Friedman's stable money growth rule, focusing on the right hand side of the identity MV = PY, which avoids the problem of unstable velocity (V), which doomed the early 1980's experiments with money growth rules.
All three alternatives have been discussed over the past several years in commentary about policy and are good subjects for academic research, which may ultimately show that many of the world's central banks have adopted the wrong rule.  

However, that raises a conundrum: if the Fed breaks its (implicit) rule, even for the sake of adopting a better rule, it risks denting its credibility....

Of course, the real problem with Evans' speech is that Ben Bernanke has no hair, so there is no reason for him to act like his hair is on fire.  That may be why bald guys are so cool.


Anonymous said... the last sentance

The Arthurian said...

"Nominal GDP targeting is a re-incarnation of Milton Friedman's stable money growth rule..."

Oh, nice. I never saw that connection before. The stable money rule evolved into a stable NGDP rule.

I always wondered about NGDP targeting, why people are confident that we won't get rising inflation rates as output fizzles to zero. I suppose if it went that way, they'd try something else.

Anonymous said...

I especially liked this graf:

"High inflation can become well-entrenched and we have to go through an episode like the policy-induced "Volcker recession," followed by a long period where the Fed re-establishes its credibility."

Heaven forbid we repeat the experience of the Volker recession.

It is as if someone with their kitchen on fire refused to use the fire extinguisher in case there were another fire.