I recently ran across a couple of tweets that look at the pros and cons of inflation. This one seems to accept the Philips Curve as a way of framing the issue:
This one opposes higher inflation:
I am not a fan of either tweet.
It’s true that using monetary policy to suddenly move inflation up or down can produce a negative short run correlation between inflation and unemployment. But we learned in the 1970s that the Philips Curve is not a useful way of thinking about inflation, for all sorts of reasons. Rather than approach the inflation issue on an ad hoc basis, we need to think about an optimal monetary policy regime. The analysis should be time consistent.
For instance, suppose you adopt a more expansionary monetary policy to avoid a rise in unemployment, and this leads to higher inflation. That sounds like a pretty clear example of a policy trade-off, right? Actually, this trade-off is largely illusionary, as it ignores the long run effects. If the more expansionary monetary policy reduces unemployment then you have two choices, continue with a higher inflation rate forever, or bring inflation down at a later date.
With a permanently high inflation rate, you are buying a few years of lower unemployment against an infinite number of years of higher inflation, not at all what readers of the tweet poll might have assumed. If inflation is reduced after remaining high for just a couple of years, then you are merely postponing the high unemployment for a few more years. Again, that’s not what the poll question seems to imply.
The second tweet is also misleading. If the Fed raised the target inflation rate from 2% to 3%, the public would hardly notice. That’s because the Fed achieves its goals by influencing aggregate demand. Because AD affects both wages and prices, modest demand-side inflation is not all that unpopular. The current inflation is highly unpopular because supply shocks are reducing living standards (especially food and energy). But using monetary policy to change the inflation target from 2% to 3% would have no impact on that sort of highly unpopular supply-side inflation.
To be clear, I don’t support raising the inflation target from 2% to 3%, which I see as a slight net negative. But the current unpopularity of inflation has little bearing on the merits of that proposal. Inflation was roughly 4% during 1982-90, and it was not a big issue. If inflation had been 3% during 1982-90 it would have been an even smaller issue.
A better reason to keep inflation at 2% is that monetary policy is more effective when it has credibility. A credible monetary policy is better able to prevent business cycles. Suddenly shifting to 3% inflation would reduce the Fed’s credibility (which is already on shaky ground.) That’s why it’s a bad idea.
READER COMMENTS
Thomas Lee Hutcheson
Jun 20 2022 at 6:33am
Probably “suddenly” shifting from 2 to 3 would be a bad idea, but having shifted during a period when the Fed was (or should have been) increasing actual inflation anyway like 2008-2020 could be OK. The issue is what is the optimal rate? 2%% 3% It ought to depend on the expected size of the shocks and the ease of downward adjustments in nominal prices to achieve optimal flexibility of relative prices. Then to when is it optimal to depart from the average target? That depends on the size of the unique shock and the ability to maintain credibility in the target, whatever it is.
As a practical matter, 2% has not been tried long enough to know if it is too low so it’s probably better to keep it and for the Fed to aim for getting expectations back to 2% rather quickly. It’ should not have let them depart from 2% for so long as it has.
Spencer Bradley Hall
Jun 20 2022 at 12:04pm
It’s incredulous. During the decade ending in 1964 aggregate monetary demand increased at an annual compounded rate of about 6 percent. In the subsequent 9 years, the increase was more than 13 percent, and in 1972-73 nearly 30 percent.
During the U.S. Golden Era in Capitalism (not optimized with 3 recessions), the annual compounded rate of increase in our means-of-payment money supply was about 2 percent. The nonbanks grew faster than the commercial banks (which made Citicorp’s Walter Wriston jealous), and therein a higher percentage of savings was utilized (through direct and indirect investment) and was also FSLIC and NCUA insured.
And during this same period, 1955-1964, the rate of inflation, based on the Consumer Price Index, increased at an annual rate of 1.4 percent. Unemployment averaged 5.4 percent.
Things ended in 1965. That’s when the commercial banksters began to outbid the non-banks for loan-funds (resulting in disintermediation of the thrifts).
The growth of time deposits shrank AD and therefore forced the FED to follow its easier monetary policy, which caused the Great Inflation.
The correct solution to FOMC schizophrenia: Do I stop because inflation is increasing? Or do I go because R-gDp is falling? is to drain the money stock while driving the banks out of the savings business, or the 1966 Interest Rate Adjustment Act. The FDIC’s reduction in deposit insurance, from unlimited for transaction deposits, to $250,000 is prima facie evidence. That’s what accelerated the drop in the unemployment rate from 8.0% in Dec. 2013 to 5.0% by Dec. 2015.
Of course, that is unpalatable to the ABA. But that does not reduce the size of the payment’s system. Savings flowing through the nonbanks never leaves the payment’s system (where all monetary savings originate). There is simply a transfer in the ownership of existing DFI liabilities within the payment’s system (an exchange in the counterparties of existing deposit liabilities, a velocity relationship).
Market Fiscalist
Jun 20 2022 at 12:23pm
I have a question:
Assume that NGDPT had been adopted at a time when supply-side issues cause some goods to spike in price and that these goods are demand inelastic so a greater proportion of aggregate spending now goes to them. Assume also that all other good (those not affected by the supply-side issues) have sticky downward prices.
If NGDP is held on trend during this supply shock then as more is being spent on the price-inflated goods clearly less will be spent on the other goods. As these prices are downwardly sticky this must mean less will be sold and this will very likely lead to a fall in employment.
In other-words: Are there situations where a supply-shock could mean that NGDPT would lead to a recession that could have been avoided if NGDP had been allowed to rise above target ?
Scott Sumner
Jun 20 2022 at 12:35pm
I think your analysis is correct (and points to the advantage of targeting total labor compensation), but I suspect that in reality the effect you describe is small.
Thomas Lee Hutcheson
Jun 20 2022 at 4:35pm
But whatever if targeted, the target is presumably optimized for the average expected shock. What should a central bank do when there is and extraordinary shock? Is auto-pilot supposed to do MORE of the work or ALL of the work?
Thomas Lee Hutcheson
Jun 22 2022 at 9:14am
But that is just a problem of following a rule inflexibly. The target NGDP target is chosen to optimize real income growth subject to expected supply side shocks. If there is a exceptionally large shock policy should accommodate it, not force the economy into recession to preserve the target.In practice, I don’t see how NGDP targeting would be better than smart inflation targeting as it is only the price part of NGDP that the Fed can affect when supply is the constraint.
vince
Jun 20 2022 at 5:30pm
So much banter about unemployment, inflation, the tradeoff, and finding the sweet spot. The real problem of course is making the pie bigger.
Mkg
Jun 20 2022 at 9:17pm
not sure if explained elsewhere, why is 2% inflation long term target better than 3%?
If wages are sticky then isn’t a higher long term (but stable and not frequently changing) target the best? 10% long term inflation such that it’s easy to give poor performers a small real pay cut every year?
Jeff
Jun 25 2022 at 4:03am
Sure, but it was also common to find passbook savings accounts paying 4-6% and CDs paying 6-8% (or more) over various durations.
Even now that the Fed has taken some action in 2022, most savings accounts are still parked at the zero bound. Not sure what if anything will ever change this state of affairs. Real interest rates for bank savers seem by far the most negative they have ever been.
I think factors like this have a major impact on how tolerable the average person perceives inflation to be. It feels like the entire economic system was overhauled in 2008 and everyone was basically asked to sacrifice so as to bail out the banks for getting into a muddle, but 14 years later there is still no trace of normalization.
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