Would NGDP targeting lead to excessive inflation?
By Scott Sumner
In talking to other economists I often hear concerns that NGDP targeting could occasionally lead to excessive inflation. Oddly, I don’t hear the opposite complaint, although there would be just as many periods of below average inflation as above average inflation. That in itself is quite revealing.
In papers like this one I have discussed why NGDP stability is better than inflation stability. I’d also encourage people to look at George Selgin’s work on why inflation is the wrong variable to stabilize.
In this post, however, I’d like to address these concerns from a slightly different perspective. I think that many economists overestimate the extent to which NGDP targeting would lead to inflation instability. The most commonly cited objection is that if the economy fell into recession, a 4% or 5% NGDP target would require a relatively high inflation rate. Inflation would be fairly low under NGDP targeting, on average, but could shoot up to 5% or more during brief periods of recession. That is the fear.
To explain what’s wrong with this fear, I’d like to describe three possible recessionary outlooks. Each one will be designated with a mammal, for reasons I’ll explain later:
Demand shock recession with procyclical inflation (horse)
Demand shock recession with countercyclical inflation (unicorn)
Supply shock recession with countercyclical inflation (zebra)
In America, demand side recessions with procyclical inflation are far and away the most common. The rate of inflation usually falls during recessions. Occasionally, as in 1974 and (perhaps) 1980, we have a recession where the rate of inflation rises. Those are supply shock recessions with countercyclical inflation. And there are no demand side recessions where inflation rises, because such a thing is impossible.
In America, horses are very common, zebra are pretty rare, and unicorns don’t exist at all. The fear that NGDP targeting would lead to lots of recessions with countercyclical inflation is akin to the fear that NGDP targeting would lead to there suddenly being lots of zebras and unicorns all over the place. It’s very unlikely to happen.
So what’s wrong with the reasoning process of those who worry that we’d see lots of cases of recession with unacceptably high inflation? Without realizing it, they are making a logical error in their thought process, holding two incompatible views at the same time:
1. NGDP is no panacea; hence we’d still have the same old business cycle to deal with.
2. Under NGDP targeting, NGDP growth would be pretty stable.
The problem is that today the overwhelming majority of business cycles are associated with strong shocks to NGDP growth. So if you accept assumption #2, then you can no longer accept assumption #1.
Since most people are skeptical about panaceas, let’s look at if from the opposite perspective. Let’s assume #1, that we have almost as many business cycles as before, even under NGDP targeting. Why would that be the case?
The answer is simple. Recall that NGDP targeting doesn’t cause supply shocks, I think everyone agrees on that point. Rather if we continue to have business cycles at almost the same pace, it must be because NGDP targeting would fail to stabilize NGDP growth, perhaps due to policy lags. We’d still have periods like 2008-09, when NGDP growth plunged sharply. But in those cases we do not see the countercyclical inflation that so worries opponents of NGDP targeting.
Oddly, (without their realizing it) their fears about countercyclical inflation are due to a weird mix of assuming NGDP targeting fails, and that it succeeds.
To conclude, either NGDP targeting fails to stabilize NGDP, in which case inflation behaves much as it does today. Or it succeeds in stabilizing NGDP, in which case we have only three or four recessions a century, when there is a huge supply shock.
In fact, even the “problem” they worry about is not a problem at all. In the cases where inflation rises sharply as growth falls sharply (say mid-2007 to mid-2008), there is no widespread outcry among economists that money is too easy and that the Fed should raise rates to reduce inflation. The profession is just as concerned about the slowing growth as the rising inflation, and thus a 12 month period of 0% RGDP growth and 4% inflation does not lead to handwringing that inflation is too high. Wages (which respond to NGDP, not inflation) don’t get unanchored when unemployment is rising, even if gasoline prices are rising. It’s certainly unfortunate that living standards take a hit, but few people (other than former ECB head Trichet) feel a need to raise interest rates to do anything about it. (And how’d that work out?)
Remember, we already have a dual mandate, and the dual mandate implies exactly the same sort of countercyclical inflation path as NGDP targeting. Fears of countercyclical inflation are groundless, that’s what we should all be rooting for. It’s a feature, not a bug. And if we get it, the business cycle will be far, far milder.
PS. I see a few signs that Greece may do a deal after all.