Avoid procyclical inflation
By Scott Sumner
A recent paper by Michael T. Kiley and John M. Roberts (both of the Federal Reserve Board) looks at option for improving monetary policy in light of the zero bound problem:
Nominal interest rates may remain substantially below the averages of the last half-century, as central bank’s inflation objectives lie below the average level of inflation and estimates of the real interest rate likely to prevail over the long run fall notably short of the average real interest rate experienced over this period. Persistently low nominal interest rates may lead to more frequent and costly episodes at the effective lower bound (ELB) on nominal interest rates. We revisit the frequency and potential costs of such episodes in a low interest-rate world in a dynamic-stochastic-general-equilibrium (DSGE) model and large-scale econometric model, the FRB/US model. A number of conclusions emerge. First, monetary policy strategies based on traditional simple policy rules lead to poor economic performance when the equilibrium real interest rate is low, with economic activity and inflation more volatile and systematically falling short of desirable levels. Moreover, the frequency and length of ELB episodes under such policy approaches is estimated to be significantly higher than in previous studies. Second, a risk adjustment to a simple rule in which monetary policymakers are more accommodative, on average, than prescribed by the rule ensures that inflation averages its 2 percent objective ± and requires that policymakers systematically seek inflation near 3 percent when the ELB is not binding. Third, commitment strategies in which monetary accommodation is not removed until either inflation or economic activity overshoot their long-run objectives are very effective in both the DSGE and FRB/US model. Finally, raising the inflation target above 2 percent can mitigate the deterioration in economic performance; the desirability of such an approach ultimately hinges on the economic costs of inflation averaging more than 2 percent and assessments of the feasibility of commitment strategies.
By promising to aim for 3% inflation after exiting the zero bound, a central bank can lower the long term real interest rate, relative to what it would be under a 2% target. But there is a cost to this policy—inflation would very likely become procyclical, which is destabilizing. Ideally you’d want inflation to be countercyclical, as this would smooth out fluctuations in employment, and make the business cycle less volatile.
One way of making inflation countercyclical is to adopt NGDP targeting.
Ben Bernanke recently suggested that the level targeting of prices offers some advantages over an inflation-targeting regime that lets bygone be bygones. He cautioned, however, that level targeting might not perform well under certain circumstances:
Price-level targeting does have drawbacks as well. For example, if a rise in oil prices or another supply shock temporarily increases inflation, a price-level-targeting central bank would be forced to tighten monetary policy to push down subsequent inflation rates, even if the economy were in a downturn. In contrast, an inflation-targeting central bank could “look through” a temporary inflation increase, letting inflation bygones be bygones.
This graph shows the idea:
A good example of this occurred in early 2008, when inflation temporarily rose well above the Fed’s 2% target, due to soaring oil prices. Bernanke is concerned that under price level targeting the Fed would have had to slow inflation sharply to bring prices back to the desired trend line. That contractionary policy would have occurred right as the economy was already being slowed by the adverse supply shock. Not good!
At this point the astute reader might ask: “But isn’t that what the Fed actually did?” Yes it is, but Bernanke is presumably too polite to throw his colleagues under the bus. Instead we are expected to realize this ourselves, and understand that in retrospect policy was far too tight in late 2008. We are also expected to know that the Fed refused to cut interest rates in the meeting after Lehman failed in September 2008, and that the Fed cited the fear of high inflation as justifying this passivity. That’s level targeting thinking. This sort of mistake (which Bernanke acknowledged in his Memoir) is exactly the sort of thing he is worried about in the quoted passage above.
Once again, NGDP targeting performs better than price level targeting. Under NGDP targeting, the Fed would not have had to tighten in mid-2008, as NGDP was slowing in early 2008, just as inflation was accelerating. Indeed the fact that (in 2008) NGDP gave a much clearer signal than inflation goes a long way toward explaining the growing interest in NGDP targeting. (That episode was cited by Nick Rowe, when he explained why he had converted from favoring inflation targeting to NGDP targeting.)