Inflation?

Skeptics often make two arguments:

1.  I shouldn’t talk about NGDP targeting as being the baseline policy.  The Fed doesn’t target NGDP; they prefer to allow lower inflation during recessions and higher inflation during booms.  That’s just how things work.

2.  ”Admit it Sumner, you are just advocating inflation.  You talk about NGDP targeting, but the bottom line is that you are advocating inflation as a way of reducing unemployment.  That policy was tried in the 1960s and 1970s, and rejected.”

Both of these arguments sound plausible, but in fact they conflict with each other.   I am not advocating “inflation” as a policy, under any plausible definition of the term.  But first let’s get some nonsense out of the way.  Words have technical definitions and they have obvious connotations.  I hope it’s clear that when people talk about “creating inflation” as a monetary policy, they aren’t talking about a 0.1% per annum rise in the CPI over the next 10 years.  If that were the definition, then almost all policymakers, even Richard Fisher, would be inflationists.  A more reasonable definition of a policy of “inflation” would be “higher than normal,” or “higher than the Fed’s 2% target.”

I’m going to provide some estimates of what I think would happen with NGDP targeting.  Then you can consider whether it is appropriate to call that policy “inflation.”  I’d like to use July 2008 as the benchmark.  This was 7 months after the peak of the previous boom and unemployment had risen to 5.6%.  That’s also the Fed’s estimate of the natural rate of unemployment.  Now I’d like to consider a policy of 5% NGDP growth over the next 6 years.  Preferably 6% for two years and then 4.5% for the following 4 years.  Let’s say that brought unemployment back to 5.6%.  One complete cycle, lasting 10 years.

If that occurred, I’d expect about 3.5% RGDP growth and 2.5% inflation for two years, while the economy recovered, and then 2.0% RGDP growth, and 2.5% inflation, over the next 4 years.  For simplicity, let’s assume the CPI inflation was also 2.5% per year for the next 6 years.  In that case inflation would have averaged 2% over the entire 10 year cycle, and it would have been procyclical, higher during booms than recessions.

Would this represent a policy switch by the Fed?  Would it be a break from past policy?  I can’t see how anyone could make that claim:

1.   During the 10 years prior to July 2008 inflation averaged higher than 2%, despite the fact that the unemployment rate actually rose during that 10 year period.  Hence any distortions caused by me cherry-picking dates should have biased the results in the opposite direction.

2.  In past business cycles the Fed usually allows higher inflation during booms, whereas inflation tends to fall during recessions, at least after the economy reaches the point where unemployment rises about the natural rate.  So the cyclical variation in inflation would also be consistent with previous Fed policy.

This is why I honestly don’t believe that NGDP targeting would be inflationary. In defense of the other side, it appears that US NGDP RGDP growth has permanently slowed from the roughly 3% trend line of the past 100 years.  If so, then my original (2009) proposal for 5% NGDP targeting, level targeting, as far as the eye can see would be inflationary relative to the baseline 2% inflation target.  That I accept.  And I also acknowledge that there are lots of NGDP targeting proposals out there, and some of them would be mildly inflationary, at least in the ordinary sense of the term.

On the other hand I’d argue that any NGDP targeting proposal actually adopted by the Fed would probably be roughly what I proposed above, and hence “non-inflationary,” under any reasonable definition of the term ‘inflation.’  Here’s Boston Fed President Rosengren joining his colleague Charles Evan in calling for NGDP targeting:

Mr. Rosengren said he did not have a firm view on what kind of measuring stick the Fed should use for a new program of asset purchases. But he suggested the Fed could target a minimum rate of nominal growth — economic growth plus inflation — of 4.5 percent. The government estimates the rate of nominal growth in the 2012 second quarter at 3.1 percent.

That approach is likely to face resistance from officials including Mr. Bernanke, who has expressed little tolerance for pushing inflation above 2 percent.

Two down, 17 to go.  I interpret Rosengren as picking a 4.5% trend because he thinks it would allow for 2% inflation the long run.   (I think that’s a bit too optimistic.)  And he seems to suggest that slightly higher NGDP growth is needed during the current recovery.  I agree.

Now I’d like to slightly extend the argument:

1.  If you think the policy Rosengren and I are calling for is inflationary, then you probably don’t understand the nature of the problem.

2.  If you view the policy I am calling for as inflationary, you are probably in the majority.  Which means that most educated observers don’t understand the nature of the problem.  Even worse, this misunderstanding among educated observers is actually one of the causes of our current 8.3% unemployment rate.

A recent quotation from James Hamilton will help me make this point clearer:

So why no new stimulus coming out of today’s meeting? If we were talking about the historical operating environment in which the policy decision is whether the Fed should raise or lower the fed funds rate by another 25 basis points, there would be no question– today the Fed would have delivered additional easing.

If the fed funds rate were currently 5.75%, and CPI inflation had averaged 1.2% over 4 years, and was expected to be about the same over the next couple years, and if unemployment were 8.3%, then yes, a Fed rate cut would be expected, and neither John Taylor nor Allan Meltzer nor Richard Fisher would call it “inflationary.”  We all agree that the economy needs more stimulus.

So let’s be honest here for a moment.  What’s really going on when people call my proposal “inflationary?”  I’m not sure, but my guess is that they are falling into the trap of assuming that money is already easy, and hence I’m calling for money to be much easier still.  Then they are perhaps subconsciously linking the term ‘inflation’ with “growth in the monetary base.”

Many years ago the term ‘inflation’ was associated with both rising prices and a rising money supply (or a currency depreciating against gold.)  Today only a few Austrians still define inflation in terms of growth in the money supply.  But if I’m right that no one would call a cut in the fed funds rate from 5.75% to 5.5% during a period of 1.2% inflation and 8.3% unemployment “inflationary”, then I have to assume that this characterization of the policy is not based on the likely rise in the CPI between 2008 and 2018, but rather on some other factor, such as the perceived impact on the monetary base.  Ironically they’d be wrong in that assumption as well, because over the medium to long term a more expansionary monetary policy means a much lower ratio of base money to GDP.