Tyler Cowen and James Surowiecki have recently discussed why it is difficult for the Fed to set a higher inflation target. They’re right. All you need to do is read conservative press accounts of the recent Fed statement, which figuratively roll their eyes at the suggestion that we might need a little more inflation. “Imagine that! The Fed thinks we need more inflation. Don’t they know inflation is a problem?”
Of course this is frustrating to macroeconomists, because if we are targeting inflation at say 2%, then it stands to reason that approximately one half of the time inflation will be too low, and one half of the time it will be too high.
But the articles that mock the Fed are not written to be read by macroeconomists, they’re to be read by the general public. And the public does believe that inflation is a problem, for several very good reasons. First, for any given nominal income, higher inflation will tend to hurt an individual worker. And second, most of the major increases in inflation have been associated with bad times. Think about 1974 or 1979, or the first half of 2008. Of course all those were associated with adverse supply shocks. You have to go back to the second half of the 1960s to find a major increase in inflation that was associated with good times.
On the other hand, if AD rises briskly and brings inflation from below normal back up to normal, most people feel better off. So when the Fed says it would like to see higher inflation, what it is really saying is that it would like to see higher AD, which as a side effect will raise inflation somewhat. For any given level of AD, higher inflation would be a bad thing, as it would represent an adverse supply shock. So why not just call for higher AD? We know that an increase in AD raises both prices and output, so it seems like what they really want is more NGDP, not higher prices. Higher NGDP is definitely needed in a demand-side recession, whereas higher inflation might or might not be a good thing.
Consider the following 7 questions:
» Which target best measures what the Fed is directly trying to influence, NGDP or inflation?
Answer: NGDP targeting. For a given level of NGDP, higher inflation would actually be harmful.
» Which policy goal sounds better to the public, higher inflation or higher nominal NGDP?
Answer: Hmmm, would you rather tell the public you are trying to boost their incomes back to prosperity levels, or that you are trying to raise their cost of living?
» Which policy is more consistent with the Fed’s dual mandate?
Answer: NGDP targeting
» Which policy doesn’t force government bureaucrats to make high subjective estimates of quality changes in products?
Answer: NGDP targeting
» Which policy is most like to prevent bubbles; NGDP or inflation targeting?
Answer: NGDP targeting, which calls for lower inflation during booms.
» Which target best avoids liquidity traps, NGDP or inflation targeting?
Answer: NGDP targeting, as 1% deflation may or may not result in a liquidity trap, depending on the trend real GDP growth rate.
» Which target is preferred by the Fed and most macroeconomists?
Answer: Inflation targeting.
The public instinctively feels the Fed should be targeting NGDP. And if they were, inflation really would be bad. Always. The public’s not stupid; they’re one step ahead of macroeconomic elite!