“If You Can’t Hit The 2% Target Why Introduce A Harder One? Because …”

The Fed and the ECB remain predictableThe Fed and the ECB remain predictable

James Alexander via Historinhas | I was pleased to report some traction in the Market Monetarist campaign to see inflation targets substituted by, or added to, an NGDP growth target. One common pushback I’ve received recently is if the central bank can’t hit a 2% target how can it hit a tougher target? It’s a reasonable question.

First, central banks in the US, UK, Euro Area and Japan, don’t want to hit their 2% targets. An odd claim, I know. But on closer inspection they now actually operate a 2% medium term target, crucially based on their own forecasts of inflation. Any time their medium term forecast approaches 2%, or worse moves above it, the noise level about interest rate paths gets very loud. The Fed even raised rates!

This targeting a target has been discussed before here, and is very depressing to economic activity, real and nominal. It ends up with actual inflation consistently below the 2% target. It is rather like most people’s two year out plans, they never seem to quite come off.

Shoot higher, achieve more

Second, moving to a 4% inflation target and missing it by 1-2% is far less damaging than missing a 2% target by 1-2%. Modest 2-3% inflation is consistent with 5% nominal growth, i.e. trend nominal growth. Stable nominal growth is the proper target for central banks, agreed by most people, even central banks.

Central banks wouldn’t have to hit 4% but turning it into a target would enable the market to believe the central banks were happy with 2-3% inflation now. Even four percent inflation, if achieved, would not be terribly damaging either. Market Monetarists are not crazy inflationists, just dull-sounding moderate inflationists, and very hostile to missing lowflation targets. The truth of the matter is that they don´t like the word “inflation”.

Third, simply moving the target obviates the need for the sort of oxymoronic “responsibly promise to do something irresponsible” thing Paul Krugman again suggests in a response to a Tony Yates blog post. No one in markets takes such nonsense seriously.

Central banks do not operate like that, and if they did markets would be worried about other stuff pretty quickly. Just change the target to something more ambitious, but still credible and responsible. It would also end the ridiculously unnecessary, frankly idle, chatter about helicopter drops.

Last an NGDP growth target is a different animal to an inflation target. NGDP is simply aggregate demand or aggregate income. It is what the central banks have almost exact control over. Inflation is a terrifically hard to calculate residual of the difference between easy to calculate nominal demand and terrifically hard to calculate real demand.

The exact balance of any nominal growth between real and inflationary growth is very difficult to divine in real time. It is, nevertheless, very important to understand and to fix if the balance is too much inflation and not enough real. That debate is no concern of the central bank. Inflation is simply the wrong target for them. They control money and therefore the other half of all economic transactions, not output. It’s a powerful tool, use it!