The July 1996 FOMC Meeting witnessed an extended discussion of inflation targeting. Interestingly it was Janet Yellen and Laurence Meyer´s first FOMC Meeting. Interesting because they are the two strong Phillips Curve adepts!
What I found of greatest interest in the discussions was Greenspan´s intervention (on page 72):
“The discussion we had yesterday was exceptionally interesting and important. I will tell you that if the 2 percent inflation figure gets out of this room, it is going to create more problems for us than I think any of you might anticipate.”
Interesting exchange (pages 50/51):
YELLEN. Mr. Chairman, will you define “price stability” for me?
CHAIRMAN GREENSPAN. Price stability is that state in which expected changes in the general price level do not effectively alter business or household decisions.
YELLEN. Could you please put a number on that? [Laughter]
CHAIRMAN GREENSPAN. I would say the number is zero, if inflation is properly measured.
YELLEN. Improperly measured, I believe that heading toward 2 percent inflation would be a good idea, and that we should do so in a slow fashion, looking at what happens along the way. My presumption based on the literature is, as Bob Parry summarized it, that given current inaccurate measurements, heading toward 2 percent is most likely to be beneficial.
Flash forward to 2014: “Of Kiwis and Currencies: How a 2% Inflation Target Became Global Economic Gospel”:
Yet even as the idea of a 2 percent target has become the orthodoxy, a worrying possibility is becoming clear: What if it’s wrong? What if it is one of the reasons that the global economy has been locked in five years of slow growth?
Some economists are beginning to consider the possibility that 2 percent inflation at all times leaves central banks with too little flexibility to adequately fight a deep economic malaise.
There is an easy step officials at the Federal Reserve could take to improve their ability to fight the next recession, but policymakers are deeply reluctant to go there: raising the central bank’s 2% inflation target.
That’s because with inflation chronically undershooting the Fed’s goal and interest rates still below 1%, they worry the central bank may not have much room to ease monetary policy further the next time the economy runs into trouble.
“Too little flexibility/constrained ability” is the standard argument put forth by all proponents of a higher inflation target.
The Letter to the Federal Reserve Board signed by 22 prominent economists on June 8 argues that:
One of these key parameters is the rate of inflation targeted by the Federal Reserve. In years past, a 2 percent inflation target seemed to give ample leverage with which the Fed could lower real interest rates. But given the evidence that the equilibrium interest rate had fallen substantially even prior to the financial crisis, and that the Fed’s short-term policy rate remained at zero for seven years without sparking any large acceleration of aggregate demand growth, a reassessment of this target seems warranted.
Economies change over time. Recent decades have seen growing evidence that developed economies have harder times generating faster growth in aggregate demand than in decades past. Policymakers must be willing to rigorously assess the costs and benefits of previously accepted policy parameters in response to economic changes.
One of these key parameters that should be rigorously reassessed is the very low inflation targets that have guided monetary policy in recent decades. We believe that the Fed should appoint a diverse and representative blue ribbon commission with expertise, integrity, and transparency to evaluate and expeditiously recommend a path forward on these questions. We believe such a process will strengthen the Fed as an institution and its conduct of monetary policy, and help ensure wise policymaking for the years and decades to come.
The Letter implicitly shows that what we all want is not a higher inflation target, but a higher level of aggregate demand (nominal spending or NGDP), and possibly a higher growth rate of aggregate demand.
The first chart below is very clear on that point. Aggregate demand fell off the trend path and there was no effort made to engineer a recovery, i.e. put the economy back on the path. All we´ve experienced is a “submerged” expansion!
The next chart clearly indicates that what the economy lacks is faster growth in aggregate demand, to enable a higher trend path of spending.
To get aggregate demand to a higher level, the Fed should increase nominal growth. Once a higher (adequate) level of demand is attained, a decision can be made on the appropriate growth rate going forward.
Over the quarter century depicted in the charts, core PCE inflation has remained low and stable. From 1993 to 2005, it averaged 1.9%. From 2006 onwards it averages 1.7%. Note that when the July 1996 FOMC Meeting that discussed inflation targets took place, core PCE was 1.9%!
Therefore, the big change has been in how the Fed has managed aggregate demand. Adequately before 2006 and poorly thereafter. Note how NGDP growth wanes as soon as Bernanke takes over, crashing in 2008 when the Fed reacted strongly to the increase in headline PCE inflation following the 2007-08 oil shock.
The wage/NGDP ratio explains all the movement in the unemployment rate. When NGDP tanks in mid-08, wage stickiness causes a strong rise in the ratio. Unemployment shoots up. When NGDP growth picks up, even if along a “submerged” expansion, unemployment comes down together with the wage/NGDP ratio. When the ratio stabilizes after mid-2015, so does the unemployment rate.
I have a hard time understanding why the concept of inflation targeting, plucked from thin air in New Zealand almost 30 years ago, remains as the only viable alternative for monetary policy. It is ironic to see prominent economists now arguing, after a long (and successful) battle to contain inflation, that it will be “good” to increase the desired inflation rate!
On the other hand, the idea that the Fed should target nominal spending (some favored level targeting while others favored growth targeting) has been around since at least the 1950s (Clark Warburton, Leland Yeager). In his 1977 Nobel Lecture, James Meade said:
Earlier I spoke of ‘price stability’ as being one of the components of ‘internal balance’. Yet in the outline which I have just given of a possible distribution of responsibilities no one is directly responsible for price stability.
To make price stability itself the objective of demand management would be very dangerous. If there were an upward pressure on prices because the prices of imports had risen or because indirect taxes had been raised, the maintenance of price stability would require an offsetting absolute reduction in domestic money wage costs; and who knows what levels of depression and unemployment it might be necessary consciously to engineer in order to achieve such a result?
Flash forward thirty years to 2007 and the “danger” materializes under Bernanke´s Chairmanship of the Fed. This mostly happens because Bernanke was known as an ardent defender of inflation targeting and would likely act accordingly (As most IT central banks did).
This is likely what Greenspan had in mind when he warned “I will tell you that if the 2 percent inflation figure gets out of this room, it is going to create more problems for us than I think any of you might anticipate”.
Later in his Lecture, James Meade said:
I have told this particular story simply to make the point that the choice between fiscal action and monetary action must often depend upon basic policy issues which should certainly be the responsibility of the government rather than of any independent monetary authority.
Perhaps the best compromise is an independent monetary authority charged so to manage the money supply and the market rate of interest as to maintain the growth of total money income on its 5-per-cent-per-annum target path, after taking into account whatever fiscal policies the government may adopt.
Later the nominal income-targeting concept was favorably discussed by Bennett McCallum in the 1980s and by Mankiw and Robert Hall in the early 1990s.
And since the Great Recession intervened, Nominal Income Level Targeting has been the banner hoisted by Scott Sumner.