"Crushing Demand" Does Not Guarantee That Inflation Expectations Will Fall
Greg Ip takes a look at my graph:
http://econ161.berkeley.edu/macro_online/lec_notes/LN_ch12.pdf
and writes:
The case against the case for a nominal GDP target: NGDP targeting will not provide a Volcker moment: "Mr Volcker’s policy did not succeed by changing people’s expectations of inflation. It succeeded by crushing demand. As unemployment moved up the Phillips Curve, inflation plummeted. Only then did inflation expectations stabilize at a lower level.
My view is that it is not either/or but rather both/and. There is a possible scenario out there in which the steep recession of 1982 did not lead to any reduction in inflation expectations and was followed by a recovery in which inflation rose back to its 1980 level rather than settling 7%/year below. Certainly that was the pattern after the 1974-75 recession: inflation falls during the recession, but because everybody thinks the Federal Reserve is likely to go back to business-as-usual the decline in this year's inflation does not produce any decline in inflationary expectations.
IMHO, the claim to have changed Federal Reserve operating procedures would not have led to any persistent reduction in inflation expectations without the crushing of demand in 1982, and the crushing of demand in 1982 would have led to a much smaller reduction in inflation expectations if not for the change in operating procedures by Volcker.
Here's the context of the Greg Ip passage:
The case against the case for a nominal GDP target: NGDP targeting will not provide a Volcker moment | The Economist: Early in his tenure as Fed chairman, Paul Volcker declared his intention to drive inflation lower. Soon after, he met with a group of businessmen. One told him, “’I listened carefully to you Mr Volcker, but I completed a wage agreement with my workers last week for 13% a year for each of the next 3 years. That’s what I think of prospects for inflation.’” Mr Volcker recalled the conversation last year, adding, “I always wondered what happened to that guy.”
Mr Volcker’s anecdote exposes the flawed reasoning behind the newborn infatuation with nominal GDP targeting…. Christina Romer... writes:
[Volcker] believed that by backing up his commitment to lower inflation with a new policy framework, he would break people’s inflationary expectations. So the Fed began to explicitly target the rate of money growth. Like the Volcker money target, [an NGDP target] would be a powerful communication tool. By pledging to do whatever it takes to return nominal G.D.P. to its pre-crisis trajectory, the Fed could improve confidence and expectations of future growth. Such expectations could increase spending and growth today
The problem with her argument is that as the story of the hapless businessman, and studies such as this one, illustrate, Mr Volcker’s policy did not succeed by changing people’s expectations of inflation. It succeeded by crushing demand…. The lesson of the Volcker disinflation is that changing expectations depends crucially on delivering on the target. Naming an inflation or money supply target is helpful, but insufficient unless the central bank demonstrates it is willing and able to achieve it.
A nominal target can affect expectations in two ways. First, it influences markets’ expectations of what the Fed will do…. If the Fed promised to hold rates low until NGDP returned to its pre-recession trend, that would no doubt help hold interest rates down. But there are many, potentially superior, ways to achieve the same thing, such as a promise to keep short-term interest rates at zero for a specified period of time, to target bond yields, or to keep rates low until a particular inflation or unemployment rate is achieved.
Second, a nominal target should encourage firms and workers to behave in a way that makes the target self-fulfilling. This channel is well established for inflation targeting: if workers and firms believe the Fed will keep inflation at 2%, they will tend to set prices and wages accordingly. Exactly how an NGDP target would be self-fulfillling is unclear to me….
I’ll grant, for now, that such a channel exists. For that channel to work, though, requires something else: private actors must believe the Fed can hit the target. In 1981, the Fed established that credibility by taking short-term interest rates to 20% and plunging the economy into its worst post-war recession. What, today, would give private actors equivalent confidence? Since 2007 the Fed has worked overtime to push employment higher and keep inflation from falling, which it can justify thanks to its 1970s vintage mandate of full employment and stable prices. Why would swapping its old framework for an NGDP target change this? Advocates claim this would justify a far more aggressive policy of quantitative easing. I am all in favor of more QE, but the Fed does not need a new framework to do that; its current mandate provides all the justification it needs.
So why doesn’t it? The Fed now finds itself in the odd position of being blasted from one side for doing too much and the other for doing too little. There is far more substance to the latter arguments than the former, but NGDP advocates base their arguments on a flawed premise: that with a different framework the Fed would have been less concerned about inflation and more about output, and would have thus eased more aggressively….
I’m not opposed to an NGDP target, I’m only trying to bring some realism to what we can expect from one, especially in a liquidity trap when fiscal policy is AWOL. No framework is perfect; NGDP simply has to be less imperfect than the alternatives. Yet bloggers and academics have the luxury of assuming their model will work in practice as it does in theory. Policy makers must contend with the consequences if it doesn’t….
Before the Fed adopts a new framework, it must conclude first that the old framework no longer works. It’s worth noting that despite an unprecedented output gap, inflation has, surprisingly, oscillated around 2% rather than sliding towards deflation territory, as many expected. This is almost certainly thanks to the stability of inflation expectations which in turn is due to the 30 years the Fed has invested in keeping inflation stable. This has had important and underappreciated, benefits: it has kept real interest rates more negative, and debt burdens less crippling, than had inflation fallen to zero or lower….
What alternative would work better? NGDP is not the only contender. Raising the inflation target might do the trick by making real rates more deeply negative. Charlie Evans’ proposal that the Fed articulate more tolerance for upside risks to inflation in order to achieve lower unemployment is promising, because it requires no radical surgery on the Fed’s existing mandate.
An NGDP target has some advantages over an inflation target, especially in responding to supply side shocks. But it could dangerously complicate policy making in more normal times…. In a model developed by Larry Ball in 1996, NGDP targeting produces systematic over- and under-shooting of both inflation and output. It is “not just inefficient, but disastrous. It causes both output and inflation to wander arbitrarily far from their long-run levels.”
There is, of course, one rather unseemly advantage to NGDP targeting, that Paul Krugman alludes to here: it is a surreptitious way of temporarily raising the inflation target without the toxic politics of doing so explicitly….
Mr Bernanke could take a page from Mr Volcker’s book and adopt an M3 target (of course, it would have to resume publication of M3), adjusted for velocity so that it approximates NGDP. Republicans and Friedmanites everywhere would applaud. One should normally be wary of a monetary policy that achieves its objectives through subterfuge, but desperate times call for desperate measures.
