Central banks can "magically" prevent disinflation
By Scott Sumner
People often say that central banks cannot magically create jobs when government lockdowns are closing down many industries. That’s correct. But it’s equally true that central banks can make the problem even worse that supply-side factors alone would mandate.
Textbook theory suggests that monetary policy should react to an adverse supply shock by allowing the rate of inflation to increase. This is one case where textbook theory is correct. An increase in inflation would help to reduce the number of debt defaults and also the amount of unemployment.
Recently, I’ve been advocating level targeting of prices, or better yet NGDP. Because NGDP level targeting is not on the table right now, I’ve suggested price level targeting (along a positive 2% trend line) as a bare minimum. I’ve received some criticism from people who point out that inflation should increase above 2% during an adverse supply shock, and that NGDP level targeting would be better.
That’s all true. But my response is that even price level targeting would be far better than the actual policy we are likely to get over the next few years. There are many indications that inflation will stay well below 2% for the foreseeable future. I can’t emphasize enough that this is the wrong policy. While monetary policy cannot magically prevent a fall in RGDP this year, it can “magically” create any inflation rate the Fed desires, even Zimbabwe-style hyperinflation. So is 2% inflation too much to ask for?
Now it’s true that I don’t know for certain that inflation is likely to fall below the 2% target, but that outcome seems overwhelming likely given the recent decline in TIPS spreads, Fed funds futures rates, commodity prices, and a wide variety of other indicators. Today’s news brings just one more example:
Prices are falling faster and steeper than JPMorgan was expecting, lead analyst Ryan Brinkman wrote in a report Monday, citing mid-month data from Manheim. The auto-auction firm’s closely watched used vehicle value index plunged 11.8% in the first 15 days of April, a decline that will easily set a record if it holds for the full month.
Instead of endless bailouts of companies, how about a monetary policy that prevents deflation from making the problem much worse?
Notice how the plunge looks even worse than 2008-09—a demand shock period!
Some false arguments:
1. “Properly measured inflation has actually risen, as the cost of buying many products (movies, restaurant meals, etc.) is now near infinity.” That may be true, but when thinking about monetary policy what matters is not “properly measured inflation”, it’s the nominal price of goods and services actually being sold. That’s the number you’d like to stabilize if you are a monetary policymaker that favors inflation targeting. We don’t target inflation at 2% because we believe that figure accurately measures the size of a raise you’d need to hold utility constant, we stabilize inflation at 2% because we believe this would tend to stabilize debt and labor markets. Movie theatre owners cannot repay nominal debts with infinite-priced tickets that never get sold.
2. “This isn’t really a supply shock, it’s a demand shock as people are unable to shop. So prices should fall.” This is a common mistake. A supply shock is a situation where RGDP growth will fall if you hold NGDP growth constant. So this is definitely a negative supply-shock. One mistake here is to conflate microeconomic-style supply and demand models with macro AS/AD models, which are totally unrelated. There is no “natural” or “free market” aggregate price level when the government has a monopoly on producing the medium of account (dollar bills and bank reserves.) The rate of inflation is whatever the Fed wants it to be, and it is certainly the case that disinflation at the moment would be a really bad outcome, something the Fed should do its best to avoid.
The Fed may currently be trying to avoid disinflation, but they aren’t trying hard enough. At a minimum, then need to institute level targeting ASAP. Then they need a “whatever it takes” approach to asset purchases, with a focus on buying safe assets.
I’m not too concerned with the April CPI, which will probably be as weak as March. My concern is that inflation in 2021 and 2022 is also likely to be weak. If so, that’s a big problem, a major policy failure.