Taylor on Inflation Targeting

Ben Bernanke has long advocated inflation targeting--the policy of a central bank announcing a numerical target for the inflation rate. In today's Wall Street Journal, John Taylor disagrees with him:

Some have argued that the lesson learned from this recent volatility experience is that the Fed should set a specific numerical target for inflation. I disagree; recent experience indicates setting such a target could increase volatility again. First, we do not know what inflation rate to target. If we choose one, we might have to change it later. Second, an explicit focus on the inflation rate may actually take emphasis away from price stability. Focusing on a numerical inflation rate tends to let bygones be bygones when there is a rise in the price level. In recent research, Yuriy Gorodnichenko and Matthew Shapiro of the University of Michigan found that Mr. Greenspan placed relatively greater weight on the price level than on the inflation rate in speeches: He was twice as likely to mention the price level as inflation; Mr. Bernanke was half as likely to mention the price level as inflation.

In sum, powerful lessons can be learned from Mr. Bernanke's start. Keep to the proven principles. Talk about the economy, not about the future of the federal funds rate. Commit to price stability without adding uncertainty about the meaning of a new inflation target.

Taylor seems to suggest that he would prefer a target path for the price level, rather than the inflation rate. The difference between price-level targeting and inflation-targeting is that price-level targeting requires making up for past mistakes. That is, under price-level targeting, if inflation comes in above target during one period, the central bank would need to produce inflation below target in some future period in order to get the price level back on its target path.

References: The Gorodnichenko-Shapiro paper that Taylor mentions can be found at the NBER. Here is my paper (published version) on the topic of price-level vs inflation targeting.

The Inflation Tax

One of my ec 10 students wonders whether it is possible to defend inflation:

Why is it such a bad thing for governments to rely more on the "inflation tax"? As long as it is applied within the context of an inflation-targeting Fed, all the negatives of inflation can be contained. That is, as long as the Fed sets a target inflation rate (say, 15%) and then uses open market techniques to bring inflation into line by taking into consideration the new money, there'll be no unexpected inflation, and therefore no inflation cost.

There are many advantages to the inflation tax, including: 1) Painless, free "collection." 2) Progressivity (those with the most accumulated assets pay the most.)

It is a provocative proposal. I don't know any economist who would endorse it, however. To explain why, let me make four points:

1. The inflation tax is not painless. There are various inefficiencies that inflation causes, even if it is steady and predictable. Those include the "shoeleather" costs of reduced real money balances, increased menu costs, spurious relative-price variability, and distortions in taxes due to the failure to have fully indexed tax laws. These are discussed in more detail in the textbook.

2. The inflation tax is probably less progressive than one might at first think. It is not a tax on all assets but only on non-interest-bearing assets, such as cash. The rich are able to keep their most of their wealth in forms that can avoid the inflation tax. (One exception is the rich in the underground economy; the inflation tax may hit criminals particularly hard.)

3. The inflation tax would raise only a modest amount of revenue. Here is a rough calculation. The monetary base is now about $800 billion. So an inflation rate of 15 percent would raise a maximum of $120 billion per year, or about 1 percent of GDP. That is an upper bound on the amount of tax revenue because, as inflation rose, the quantity of money demanded would fall, reducing the size of the tax base. (This is a standard "Laffer curve" argument, applied to the inflation tax.)

4. For reasons that are not fully understood, high inflation tends to be volatile inflation. A stable and predictable 15 percent inflation seems possible as a matter of economic theory, but it is rarely if ever observed. If we take this empirical regularity as a constraint, then choosing high inflation entails choosing volatile inflation, which increases uncertainty.

These are the reasons that most economists would be averse to a proposal of steady 15 percent inflation. But has some economist done a detailed and convincing cost-benefit calculation, weighing all the pluses and minuses, to figure out the optimal inflation rate? Not to my knowledge.

To read more about the inflation tax and the optimal rate of inflation, click here, here, and here.

How to Decentralize Monetary Policy

Today's Wall Street Journal reports:

Federal Reserve policy makers raised interest rates last month in part because markets expected them to do so, and they figured failure to act might hurt their credibility as inflation fighters, minutes of the meeting suggest.

Some people might view this response as wimpy--doing what financial markets want rather than showing real leadership. But one can view this approach as a step toward decentralizing monetary decisionmaking.

Suppose the Fed has a long-term inflation target. And suppose the Fed followed this rule:

Look at the market's forecast of interest rates and inflation over the next few years. If the market expects inflation above target, set a path for interest rates a bit higher than the market expects. If the market expects inflation below target, set a path for interest rates a bit lower than the market expects. If the market expects inflation to come in on target, set a path for interest rates equal to what the market expects.

This might seem circular: The Fed is responding to the market, and the market is responding to the Fed. But there is nothing wrong with that. Economists are used to simultaneity.

Of course, the market will catch on to the policy, but that's okay. In fact, it is ideal. We end up in a fixed-point equilibrium in which the market expects the Fed will hit its inflation target. In this equilibrium, the market's forecast of interest rates will tell the Fed what it needs to do to accomplish what it wants to accomplish.

Which inflation rate?

With oil prices and other commodity prices rising, many commentators are starting to worry about inflation. These events raise the question in the minds of some astute observers of which inflation rate central bankers should focus on.

Ricardo Reis and I addressed this question in a paper a few years ago, called What Measure of Inflation Should a Central Bank Target? (published version). The abstract:

This paper assumes that a central bank commits itself to maintaining an inflation target and then asks what measure of the inflation rate the central bank should use if it wants to maximize economic stability. The paper first formalizes this problem and examines its microeconomic foundations. It then shows how the weight of a sector in the stability price index depends on the sector's characteristics, including size, cyclical sensitivity, sluggishness of price adjustment, and magnitude of sectoral shocks. When a numerical illustration of the problem is calibrated to U.S. data, one tentative conclusion is that a central bank that wants to achieve maximum stability of economic activity should use a price index that gives substantial weight to the level of nominal wages.

With this conclusion in mind, let's look at growth in nominal compensation per hour:

As judged by this series, inflationary pressures look reasonably well contained at the moment.

But notice what happened in the late 1990s. Reis and I commented on this episode in our conclusion:

Consider how a monetary policymaker in 1998 would have reacted to these data. Under conventional inflation targeting, inflation would have seemed very much in control, as the CPI inflation rate of 1.5 percent was the lowest in many years. By contrast, a policymaker trying to target a stability price index would have observed accelerating wage inflation. He would have reacted by slowing money growth and raising interest rates (a policy move that in fact occurred two years later). Would such attention to a stability price index have restrained the exuberance of the 1990s boom and avoided the recession that began the next decade? There is no way to know for sure, but the hypothesis is intriguing.

Phelps on the Taylor Rule

Ned Phelps has an op-ed in the yesterday's Financial Times arguing against the Federal Reserve adopting a Taylor rule for monetary policy (which I discussed in one of my last ec 10 lectures). An excerpt:

The rule advocated now, however, would set the short rate of interest. In the standard textbook rule, created by John Taylor, the Stanford University economist, in the 1980s, the real short rate (the money interest rate less the inflation rate) is set higher the greater is inflation, and lower the greater is unemployment. If perchance the inflation rate is at its "target" and unemployment is at the "natural unemployment rate", the real interest rate is to be set equal to the "natural interest rate" -- the real rate businesses could afford to pay if unemployment were at the natural unemployment rate. Mr Taylor took the natural rates to be constants.

Commitment to an interest rate rule would be dangerous because the product and labour markets could not rescue the economy from the consequences of an error in the rule. The natural interest rate is complicated to estimate. Should the natural interest rate be below the level the rule took it to be, no fall in prices and wages could restore unemployment to its natural rate: their fall would pull down the money supply with them, leaving no net restorative effect.

I think Ned exaggerates the danger here, for two reasons.

1. If the Fed overestimates the natural interest rate (essentially the constant in the Taylor rule), it will tighten monetary policy too much. The economy would respond with a lower rate of inflation, which in turn would induce the Fed to lower interest rates. In the end, overestimating the natural interest rate would mean a steady-state inflation rate below target. This is hardly a catastrophe. No one really knows if the optimal inflation rate is 0, 1, or 2 percent, so there is no big problem if we get a steady-state inflation rate a bit below the stated target. (A digression: Perhaps the optimal inflation rate is 3.14159265, which is why we always write inflation as π.)

2. Ned seems to be knocking down a strawman. I don't recall hearing anyone recommend a Taylor rule as a hard and fast rule to which the Federal Reserve would commit itself. The Taylor rule is more like a rule of thumb or a guideline for monetary policymakers, like the Pirate's code in "Pirates of the Caribbean: The Curse of the Black Pearl" (which, by the way, is a perfect movie if you have kids about 8 to 12 years old). As far as I know, no practical economist or central banker has proposed following a Taylor rule religiously.

Update: Brad DeLong helpfully find the quotation from the movie, where the villain Barbosa says:

First, your return to shore was not part of our negotiations nor our agreement, so I must do nothin'. And secondly, you must be a pirate for the Pirate's Code to apply, and you're not. And thirdly, the Code is more what you'd call "guidelines" than actual rules. Welcome aboard the Black Pearl, Miss Turner.

Why I fear the Fed may be overdoing it

I thought I might explain my fear that the Fed is in the process of tightening too much. Let me begin, however, with two points of agreement with the monetary hawks.

First, I agree that monetary and fiscal policymakers are partly to blame for the recent inflation surge. In fact, I warned about overheating in a February 2021 column in the New York Times.

Second, I agree that some significant amount of monetary tightening is in order. That is especially true because fiscal policymakers are doing little to help contract aggregate demand. Instead, actions like student loan forgiveness are doing the opposite. The so-called Inflation Reduction Act is a feckless political smokescreen.

The question is, how much monetary tightening is in order? This question is hard, and anyone who claims to know the answer for sure is not being honest either with you or with themselves. The reason it is hard is that monetary policy works with a substantial lag. It is no surprise that the recent Fed tightening hasn't had much impact on inflation yet. That is no reason to think the Fed needs to tighten a lot more. The Fed made the mistake of waiting for inflation to appear before starting to tighten. It would be a similar mistake to wait for inflation to return to target before stopping the tightening cycle.

The Taylor rule suggests one way to calibrate the problem. This rule of thumb says that the real interest rate needs to rise by 0.5 percentage points for each percentage point increase in inflation. The yield on the 5-year TIPs, which incorporates recent and near-term expected changes in monetary policy, has risen by 330 basis points over the past year. According to the Taylor rule, that would be appropriate if inflation had risen by 6.6 percentage points. Has it?

The answer depends on what measure of inflation one looks at. If you look at the CPI, then yes, the inflation surge could justify such a large tightening. But some of that inflation surge was due to temporary supply-side events. (Team Transitory was wrong, but not entirely wrong.) Wage inflation has increased only about 3 percentage points. By this metric, which can be viewed as a gauge of ongoing inflation pressures, a smaller monetary tightening would be appropriate.

A related issue is whether the normal real interest rate, sometimes called r*, is higher than the Fed previously thought. It might be. But I am inclined to think that there are long-run structural changes that explain the decline in real interest rates, as I explained in a recent Brookings paper. Those forces are likely to keep r* low in the years to come.

Another data series that I keep an eye on--though it is out of fashion these days--is the money supply. M2 surged before the large increase in inflation. Economists who watch the money supply, like Jeremy Siegel, were among the first to call the inflation surge. Yet over the past year, M2 has grown a mere 3.1 percent.

Finally, another factor is that the monetary tightening is occurring worldwide. Standard monetary rules like the Taylor rule do not explicitly incorporate the international linkages. But perhaps they should. Some of upcoming contraction of the U.S. economy will be attributable to the policies of foreign central banks. It is hard to say how much.

So, if I were one of the Fed governors, I would recommend slowly easing their foot off the brake. That means when the next decision comes and they debate an increase of, say, 50 or 75 basis points, choose the smaller number.

At this point, a recession seems a near certainty due, in part, to the Fed's previous miscalculations that led monetary policy to be too easy for too long. There is nothing to be gained from making the recession deeper than necessary. The second mistake would compound, not cancel, the first one.

The ZLB in My Favorite Textbook

In a recent blog post, Paul Krugman writes:

As far as I know, among basic textbooks only Krugman/Wells even talks about the liquidity trap.

This is probably a true statement.  It is not that other books don't cover the topic, however.  It is just that Paul Krugman doesn't know it.

FYI, here is what the leading introductory text says about the topic:

The Zero Lower Bound

 

As we have just seen, monetary policy works through interest rates. This conclusion raises a question: What if the Fed’s target interest rate has fallen as far as it can? In the recession of 2008 and 2009, the federal funds rate fell to about zero. What, if anything, can monetary policy do then to stimulate the economy?

 

Some economists describe this situation as a liquidity trap. According to the theory of liquidity preference, expansionary monetary policy works by reducing interest rates and stimulating investment spending. But if interest rates have already fallen almost to zero, then perhaps monetary policy is no longer effective. Nominal interest rates cannot fall below zero: Rather than making a loan at a negative nominal interest rate, a person would just hold cash. In this environment, expansionary monetary policy raises the supply of money, making the public’s asset portfolio more liquid, but because interest rates can't fall any further, the extra liquidity might not have any effect. Aggregate demand, production, and employment may be "trapped" at low levels.

Other economists are skeptical about the relevance of liquidity traps and believe that a central bank continues to have tools to expand the economy, even after its interest rate target hits its lower bound of zero. One possibility is that the central bank could raise inflation expectations by committing itself to future monetary expansion. Even if nominal interest rates cannot fall any further, higher expected inflation can lower real interest rates by making them negative, which would stimulate investment spending. 

A second possibility is that the central bank could conduct expansionary open-market operations with a larger variety of financial instruments than it normally uses. For example, it could buy mortgages and corporate debt and thereby lower the interest rates on these kinds of loans. The Federal Reserve actively pursued this last option during the downturn of 2008 and 2009.

Some economists have suggested that the possibility of hitting the zero lower bound for interest rates justifies setting the target rate of inflation well above zero. Under zero inflation, the real interest rate, like the nominal interest, can never fall below zero. But if the normal rate of inflation is, say, 4 percent, then the central bank can easily push the real interest rate to negative 4 percent by lowering the nominal interest rate toward zero. Thus, moderate inflation gives monetary policymakers more room to stimulate the economy when needed, reducing the risk of hitting up against the zero lower bound and having the economy fall into a liquidity trap.

What is the Fed to do?

This picture from Paul Krugman is deeply troubling. It shows the real interest rates on corporate bonds, with the expected rate of inflation from the spread between 20-year TIPS and 20-year Treasury rates.

The Fed is supposed to cut real interest rates as the economy weakens, but the opposite seems to be happening. The problem is that the Fed is close to its zero lower bound on the federal funds rate, perceptions of credit risk are rising, and expected inflation is falling. Indeed, as I pointed out yesterday, people are increasingly concerned about possible deflation.

What is the Fed to do (other than pray)? Expectations management is the key.

Here is one idea. Suppose the Fed cuts the federal funds rate once again to, say, 25 basis points. More important, at the same time, the Fed announces a target path for the price level as measured by the core CPI. The price path might be, say, an increase of 2 or 3 percent per year. The Fed promises not to raise the fed funds rate over the next 12 months and, after that, will keep the funds rate at that low level as long as the price level is significantly below its target path.

The credibility of the promise is paramount. To get long-term real interest rates down, the Fed needs to convince markets that it will vigorously combat deflation, and that if deflation happens in the short run, the Fed will reverse it by subsequently producing extra inflation. A credible promise of subsequent price reversal after any deflation ensures that long-term expected inflation stays close to the inflation rate implied by the Fed's target price path. Monetary economists will recognize that this policy is price-level targeting rather than inflation targeting.

Would such an announcement by the Fed have the credibility it needs to work? Would such a monetary policy be enough to avoid a deep downturn? I am not sure. That's where the prayer part comes in.

Lucas on Monetary Policy

In today's Wall Street Journal (subscription required), Robert Lucas opines on the Fed. An excerpt:

Mortgages and Monetary Policy
By Robert E. Lucas, Jr.

In the past 50 years, there have been two macroeconomic policy changes in the United States that have really mattered. One of these was the supply-side reduction in marginal tax rates, initiated after Ronald Reagan was elected president in 1980 and continued and extended during the current administration. The other was the advent of "inflation targeting," which is the term I prefer for a monetary policy focused on inflation-control to the exclusion of other objectives. As a result of these changes, steady GDP growth, low unemployment rates and low inflation rates -- once thought to be an impossible combination -- have been a reality in the U.S. for more than 20 years....

The need for a lender-of-last-resort function is one qualification to the discipline of inflation targeting, but it is a necessary one. There is a second line of argument that seems to me much less compelling. It starts with the fact that monetary policy necessarily affects future inflation rates, not the current rate: That has already been determined when the open market committee meets. We also know that whatever funds rate target is chosen, all kinds of others forces -- anything that happens to the real economy -- will affect next quarter's rate of inflation, or next year's. So we would like to forecast these other forces as well as possible and take them into account.

There is nothing wrong with this logic, but how useful it is depends on how good we are at forecasting the non-monetary determinants of prices. In fact, inflation forecasting is notoriously one of the squishiest areas of economic statistics. In this situation, it is all too easy for easy money advocates to see a recession coming and rationalize low interest rates. They could be right -- who really knows? -- and in any case we may not know enough to prove them wrong.

So I am skeptical about the argument that the subprime mortgage problem will contaminate the whole mortgage market, that housing construction will come to a halt, and that the economy will slip into a recession. Every step in this chain is questionable and none has been quantified. If we have learned anything from the past 20 years it is that there is a lot of stability built into the real economy.

To me, inflation targeting at its best is an application of Milton Friedman's maxim that "inflation is always and everywhere a monetary phenomenon," and its corollary that monetary policy should concentrate on the one thing it can do well -- control inflation. It can be hard to keep this in mind in financially chaotic times, but I think it is worth a try.

King on Monetary Policy

Mervyn King, the most charming central banker I know, offers his views about monetary policy in a globalized economy:

Some of you may be tempted to think that because the growth of the Chinese economy has affected key prices in our own economy, inflation in Britain is now largely determined overseas. Low inflation in industrialised countries, it is argued, is made in China. As with the Arthurian legends, epitomised by King Arthur’s Round Table above us, that too is a myth. Despite large changes in relative prices, the average change in prices – inflation – has been remarkably stable. Indeed, it is striking that in a decade in which prices moved so much, overall inflation was more stable than in any decade for a hundred years. It was a decade that in my first speech as Governor, I described as NICE– a non-inflationary consistent expansion.

How can inflation be stable when individual prices move around so much? The explanation is that inflation is the result, in the old adage, of too much money chasing too few goods. Inflation arises when the total amount of money spending (or nominal demand) in the economy is greater than the value today of the available goods and services. When the Bank of England changes Bank Rate to keep consumer price inflation close to the target of 2%, we influence – albeit imprecisely and with a time lag – the amount of money spent in the economy and so the inflation rate.

In short, inflation is made at home.

Krugman vs Cecchetti on Inflation

In today's NY Times, economist Paul Krugman writes about the outlook for inflation and monetary policy:

Over the last few weeks monetary officials have sounded increasingly worried about rising prices. On Wednesday, Richard Fisher, the president of the Federal Reserve Bank of Dallas, declared that inflation ''is running at a rate that is just too corrosive to be accepted by a virtuous central banker.'' I'm worried too -- but not about recent price increases. What worries me, instead, is the Fed's overreaction to those increases....

Much of the recent rise in core inflation probably represents the delayed effect of the big run-up in fuel prices a few months ago. And unless something else happens to drive up oil prices -- like, to give a wild example, a military strike on Iran -- inflation will probably subside in the months ahead.

Two days ago, economist Steve Cecchetti offered a different take on the situation:

This morning's CPI report confirms many people's worst fears. Inflation is up. The all items CPI rose 5.5% at an annual rate for the month of May, and is up 4.2% since May 2005. This is well above recent (or acceptable) trends. Core measures faired little better, with the CPI excluding food and energy up 3.6% (a.r.) in May, and 2.4% over the past 12 months. The Median CPI computed by the Federal Reserve Bank of Cleveland increased 4.3% (a.r.) for the month, and is up 2.7% for the year. Importantly, the trends in all of these numbers are up. This time around, the detail of the report is worse than the headline numbers....

The implications for monetary policy are pretty clear. With inflation at 3%, one percentage point above the 2% implicit target of the FOMC, we can now expect the federal funds rate to rise to at least 6%. But the risk is that it will not stop there. I could easily see the inflation trend rising to 3.5% over the next 6 months, and then the federal funds rate will have to go much higher.

For those who don't know him, I should note that Steve is a professor at Brandeis and author of a leading textbook on money and banking; he was previously Director of Research at the Federal Reserve Bank of New York. This does not mean that he is right about the inflation outlook, but it does mean that his view is worth taking seriously.

Update: Read more in my next post on forecasting inflation.

Follow or Break the Rule?

Lars Christensen plots with recent data a version of the Taylor rule I proposed some years ago (published here).  I suggested this rule as an approximate description of Alan Greenspan's monetary policy in the 1990s. Here is Lars's plot:

Click on graphic to enlarge 

 

I based this rule (the green line) on data only from the 1990s, but notice that it does reasonably well until 2009.  The red line is the rule with parameters estimated from the later period.

Taken at face value, the rule suggests that it is time for the Fed to start raising the federal funds rate.  If you believe this rule was reasonably good during the period of the Great Moderation, does this mean the Fed should start tightening now, as the economy gets back to normal? 

Maybe, but not necessarily. There are two problems with interpreting such rules today.

The first and most obvious problem is that odd things have been happening in the labor market for the past several years. The unemployment rate (one of the right hand side variables in this rule) may not be a reliable indicator of slack.

The second and more subtle problem is the nagging issue of the zero lower bound.  For several years, the rule suggested a target federal funds rate deeply in the negative territory.  We are out of that range now, but should the past "errors" influence our target today?  An argument can be made that because the Fed kept the target rate "too high" for so long (that is, at zero rather than negative), it should commit itself now to keeping the target "too low" as compensation (that is, at zero for longer than the rule recommends).  By systematically doing so, the Fed encourages long rates to fall by more whenever the economy hits the zero lower bound. Such a policy might lead to greater stability than strict adherence to the rule as soon as we leave negative territory.

The time for the Fed to raise the target rate may be soon, but I don't think we are quite there.

Update: Ricardo Reis writes to me the following useful observation:

There is another (related) argument for not raising rates now to offset shortfalls in the past. It is not about the interest rate. It is about the price level, the ultimate goal of monetary policy and measure of its performance.

If you plot the PCE deflator, there is a clear shortfall relative to a 2% price-level target. A 2% price level target fits very well during Greenspan's time.  By the end of 2008, we were exactly on the 1992-target. But when I look at that plot starting in 2009 until the most recent data I see a gap.

A price-level target rule is optimal in normal times (Ball, Mankiw, and Reis) but is also an optimal policy in response to the dangers of the zero lower bound (Woodford). We have to catch up for the shortfall in the price level right now. And if you look at inflation expectations from surveys or markets, there seems to be no catch up expected, indicating that policy is still too tight.

The Next Round of Ammunition

With the Fed having cut its target interest rate today to a range of zero to 1/4 percent, many people will be asking whether the central bank has run out of ammunition. A good question. Obviously, the next step is not going to be further cuts in the federal funds rate. But there is still more the Fed can do.

Notice this passage in the Fed's press release (emphasis added):

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

The phrase "for some time" is aimed at managing expectations in order to keep long-term interest rates down.

The next step for the Fed is to drop the "price stability" rhetoric. The Fed has never been truly committed to stable prices. After all, inflation during the Volcker-Greenspan era averaged about 2 to 3 percent. The Fed could have lowered inflation to zero if it had wanted. Now that zero, or even below zero, is a possibility, the Fed needs to convince people that we are going back to the normal inflation rate of 2 to 3 percent.

Let me suggest this wording for the Fed's next press release:

The Committee recognizes that moderate inflation would be desirable under the present circumstances. In particular, the overall level of prices a decade hence should be about 30 percent higher than the price level today. The committee anticipates keeping the stance of monetary policy sufficiently accomodative to achieve that degree of inflation over the coming decade.

That is, even if the Fed cannot reduce nominal interest rates, it can reduce real interest rates by committing to a modest amount of inflation.

Some would view this as a radical change in monetary policy. In some ways, it would be. Given how weak the economy is, however, a bit of radicalism may be called for. I am more comfortable having the Fed commit itself to modest inflation than having the federal government commit itself to a trillion dollars of new spending. The more we can rely on monetary rather than fiscal policy to return the economy to full employment and sustainable growth, the better off future generations of taxpayers will be.

The abandonment of "price stability" would be the modern equivalent of Roosevelt's abandonment of the gold standard. Of all the things that Roosevelt did to get the economy out of the Depression, jettisoning the gold standard was the most successful. Today, monetary policy is fettered not by gold but by fear of inflation. Perhaps it is time is get over that fear, at least for a while. As Jim Tobin said in an earlier era, there are worse things than inflation, and we have them.

---
Update: A reader points out to me that Paul Krugman seems miffed that I failed to cite his contribution to the large literature on expectations management by the central bank. Sorry, Paul. I actually do like Paul's paper on the topic quite a lot, and I cite it in my intermediate macro text when I discuss the liquidity trap (see footnote 5 on page 325 of the 6th edition).

It is funny. For academics, it is an occupational hazard to feel that your work is insufficiently cited. I had always assumed that the feeling would go away after winning a Nobel prize. I guess I was wrong.

I agree with Paul Krugman

As my regular blog readers know, Paul Krugman and I often do not see eye to eye.  So, once in a while, it might be useful to point out those times when we actually agree.

In a recent post on commodity prices, Paul says, "Volatile prices are volatile, which is why they shouldn’t be used to determine monetary policy."  I agree, and I suspect many other macroeconomists would as well.

I once wrote a paper on this topic with Ricardo Reis, called "What Measure of Inflation Should a Central Bank Target?" (published link)  Here is the abstract:

This paper assumes that a central bank commits itself to maintaining an inflation target and then asks what measure of the inflation rate the central bank should use if it wants to maximize economic stability. The paper first formalizes this problem and examines its microeconomic foundations. It then shows how the weight of a sector in the stability price index depends on the sector’s characteristics, including size, cyclical sensitivity, sluggishness of price adjustment, and magnitude of sectoral shocks. When a numerical illustration of the problem is calibrated to U.S. data, one tentative conclusion is that a central bank that wants to achieve maximum stability of economic activity should use a price index that gives substantial weight to the level of nominal wages.

As the graph below illustrates, the price of labor does not show any significant inflationary pressures right now:

Click on graphic to enlarge.

For more on this topic, see a recent post by MIT grad student Matt Rognlie.

A Jump in Expected Inflation

Jim Hamilton, one of the most astute macroeconomist-bloggers, provides this great graphic. It shows forward inflation compensation during the market trading of Tuesday last week. This measure is based on the spread between nominal bond yields and real (inflation-protected) bond yields. It reflects the market's expectation of future inflation--to be precise, the expectation of the average five-year inflation rate starting five years from now. Click through to the Hamilton link for more details if you are not familiar with this sort of data.

The jump upward at 2 pm occurred just after the Fed's announcement of a surprisingly large cut in its target interest rate. The apparent change in expected inflation is not large--about 5 basis points--but it is striking nonetheless. It shows clearly how easier monetary policy raises expected inflation.

A Mono Mandate for the Fed?

Along with Congressman Paul Ryan, economist John Taylor calls for a revision of the Federal Reserve's mandate:

Quantitative easing is part of a recent Fed trend toward discretionary and away from rules-based monetary actions. The consequences of this trend are clear: The Fed's decision to hold interest rates too low for too long from 2002 to 2004 exacerbated the formation of the housing bubble. And while the Fed did help to arrest the ensuing panic in the fall of 2008, its subsequent interventions have done more long-run harm than good....

Congress should reform the Federal Reserve Act, particularly the section of the act that establishes the Fed's dual mandate. The Fed should be tasked with the single goal of long-run price stability within a clear framework of overall economic stability. Such a reform would not prevent the Fed from providing liquidity, serving as lender of last resort, or cutting interest rates in a financial crisis or a recession.

I am skeptical. If the Fed's mandate were different, monetary policy today might well be the same. That is, with inflation now below its target, the Fed could be pursuing QE2 even if it were operating under the proposed mono mandate. Looking ahead, the Fed believes that inflation too low, even deflation, is a larger risk than inflation too high, so it is engaging in expansionary policy to get inflation back on target.

What would Alan do?

There has been a lot of talk lately about whether the Fed will continue raising interest rates or pause for a while. I don't know the answer, but here is one way to think about it.

About five years ago, I wrote a paper on monetary policy in the 1990s. I estimated the following simple formula for setting the federal funds rate:

Federal funds rate = 8.5 + 1.4 (Core inflation - Unemployment).

Here "core inflation" is the CPI inflation rate over the previous 12 months excluding food and energy, and "unemployment" is the seasonally-adjusted unemployment rate. The parameters in this formula were chosen to offer the best fit for data from the 1990s.

Right now, core inflation is 2.4 percent, and unemployment is 4.6 percent. This formula says the federal funds rate should be set at 5.42 percent--just 17 basis point above the current target of 5.25 percent.

So we now seem to be very close to the rate that Alan Greenspan would have set under these conditions.

What's new in the new edition?

As I have noted in a previous post, the sixth edition of my principles text has recently been released.  Finding things to update was easy.  When the last edition was sent to the printer, President Obama had not yet clinched the Democratic nomination!  Just think of everything that has happened in the economy and economic policy since then.

If you wonder more specifically what you will find in the new edition that was not in the last one, here is a list.

Chapter 1
New Case Study: The Incentive Effects of Gasoline Prices
New paragraph on the recent downturn added under Principle 10
Two new problems

Chapter 2
New In the News box: The Economics of President Obama
Table 1 updated and substantially expanded
New Cartoon in Appendix

Chapter 3
Tiger Woods changed to Tom Brady in in-text example.
New Question for Review
New problem

Chapter 4
New article for the In the News box: Price Increases After Disasters

Chapter 5
New FYI box: A Few Elasticities from the Real World

Chapter 6
New In the News box: Should Unpaid Internships Be Allowed?

Chapter 7
New problem

Chapter 8
New In the News box: New Research on Taxation

Chapter 9
New In the News box: Trade Skirmishes, about U.S. tariffs on Chinese tires and the retaliatory response
New problem

Chapter 10
New In the New box: The Externalities of Country Living
New In the News box: Cap and Trade
New problem

Chapter 11
Introduce new term: Club goods.
New In the News box: The Case for Toll Roads
Two new problems

Chapter 12
New In the News box: The Temporarily Disappearing Estate Tax
New In the News box: The Value Added Tax

Chapter 13
New problem

Chapter 14
New problem

Chapter 15
New In the News box: President Obama’s Antitrust Policy
Two new problems

Chapter 16
Two new problems

Chapter 17
New In the News box: The Next Big Antitrust Target?
New problem

Chapter 18
New problem

Chapter 20
New In the News box: What’s Wrong with the Poverty Rate?
New In the News box: The Root Cause of a Financial Crisis
New problem

Chapter 21
New In the News box: Backward-sloping Labor Supply in Kiribati
Three new problems

Chapter 22
New In the News box: Arrow’s Problem in Practice
New In the News box: Sin Taxes

Chapter 23
New In the News box: Beyond Gross Domestic Product
New problem

Chapter 24
New In the News box: Shopping for the CPI
New problem

Chapter 25
New In the News box: One Economist’s Answer (to what makes a nation rich)

Chapter 26
New FYI box: Financial Crises
Two new problems

Chapter 27
New In the News box: A Cartoonist’s Guide to Stock Picking
New In the News box: Is the Efficient Markets Hypothesis Kaput?
Two new problems

Chapter 28
New In the News box: The Rise of Long-term Unemployment
New In the News box: How Much Do the Unemployed Respond to Incentives?

Chapter 29
New In the News box: Mackereleconomics
New Section on Bank Capital, Leverage, and the Financial Crisis of 2008-2009
Much revised section on the tools of monetary policy. It now includes a discussion of the Term Auction Facility and the Fed’s payment of interest on reserves.
New In the News box: Bernanke on the Fed’s Toolbox
New Question for Review
New problem

Chapter 30
New FYI box: Hyperinflation in Zimbabwe
New section: Inflation is Bad, But Deflation May Be Worse
New In the News box: Inflationary Threats

Chapter 31
Box on Euro updated to discuss problems in Greece
New problem

Chapter 32
New In the News box: Alternative Exchange-Rate Regimes

Chapter 33
New In the News box: The Social Influences of Economic Downturns
New Case Study: The Recession of 2008-2009
New In the News box: Modern Parallels to the Great Depression

Chapter 34
New FYI box on the Zero Lower Bound
New In the News box: How Large is the Fiscal Policy Multiplier?

Chapter 35
New In the News box: Do We Need More Inflation?

Chapter 36
New (sixth) debate added on spending hikes vs tax cuts to fight recessions
New FYI box on inflation targeting
New In the News box: What is the Optimal Inflation Rate?
New In the News box: Dealing with Debt and Deficits

Observations on Negative Interest Rates

My article on negative interest rates generated more than the usual volume of email, some of it quite heated. While I cannot possibly respond to all of it, let me add a few wonkish comments about the topic, from a variety of perspectives:

1. If r is the real interest rate, then the relative price of consumption tomorrow in terms of consumption today is 1/(1+r). Is there anything in economic theory that requires this relative price to be less than one? Unless consumption goods are costlessly storable, which they aren't, I do not think so. Just as the price of apples can be more or less than the price of pears, the price of consumption tomorrow can be more or less than the price of consumption today. If people are eager to defer consumption, then consumption tomorrow could well be more expensive than consumption today--that is, the equilibrium real interest rate could be negative.

2. Most ec 10 students begin thinking about the interest rate in terms of the supply and demand for loanable funds. That works perfectly here. The recent declines in housing and stock-market wealth have increased Americans' propensity to save. That is, we have increased the supply of loanable funds. There is no reason to presume that the equilibrium interest rate consistent with full employment is necessarily in the upper right quadrant of the Cartesian plane.

3. Higher uncertainty drives up risk premiums. In a Lucas asset pricing model, a higher risk premium could occur in equilibrium with a lower risk-free rate, rather than a higher return on risky capital. As uncertainty increases, the risk-free rate could easily be pushed into the negative region. (If you need convincing on this point, see equation 3.9 in this paper.)

4. The above three points are aimed at establishing that there is nothing particularly radical in the idea of a negative real interest rate from the standpoint of economic theory. But are we really there? That is an empirical question. When I calibrate my favorite version of the Taylor rule using the most recent data, I get a target for the nominal federal funds rate of about negative 1 percent. That means an even more negative target for the real interest rate, as long as expected inflation is still positive. And given the forecasts of inflation and unemployment, we are likely to get further into the negative region in the months to come.

5. If we want to prop up aggregate demand to promote full employment, what is the alternative to monetary policy aimed at producing negative real interest rates? Fiscal policy. Essentially, the private sector is saying it wants to save. Fiscal policy can say, "No you don't. If you try to save, we will dissave on your behalf via budget deficits." That fiscal dissaving would push equilibrium interest rates upward. But is that policy really welfare-improving compared to allowing interest rates to fall into the negative region? If people are feeling poorer and want to save for the future, why should we stop them? Unless we think their additional saving is irrational, it seems best to try to funnel that saving into investment with the appropriate interest rate. And given the available investment opportunities, that interest rate might well be negative.

The IS-LM Model

A reader emails me the following question:

Dear professor Mankiw:

I like your blog a lot. I daily go to it in order to read good economics. Keep up the excellent work!

May I ask you why economists authors of textbooks on intermediate macroeconomics like you keep using the IS-LM model even though we already know that the Central Bank does not set the monetary supply. Instead, it does set the interest rate. Shouldn´t you do like Wendy Carlin and David Soskice in their recent and fantastic book "Macroeconomics: Imperfections, Institutions and Policies" where they replace the LM curve by a monetary rule (for example, a Taylor rule). Wouldn´t that be more representative of what occurs in reality rather than supposing that the institution gets the control of the quantity of money?

Thanks for your attention in advance.

Best,
[name withheld]

To answer this question, let me start with an excerpt from Chapter 11 of my intermediate macro text. This passage shows how I handle these issues when teaching this course:

What Is the Fed's Policy Instrument--The Money Supply or the Interest Rate?

Our analysis of monetary policy has been based on the assumption that the Fed influences the economy by controlling the money supply. By contrast, when the media report on changes in Fed policy, they often just say that the Fed has raised or lowered interest rates. Which is right? Even though these two views may seem different, both are correct, and it is important to understand why.

In recent years, the Fed has used the federal funds rate--the interest rate that banks charge one another for overnight loans--as its short-term policy instrument. When the Federal Open Market Committee meets every six weeks to set monetary policy, it votes on a target for this interest rate that will apply until the next meeting. After the meeting is over, the Fed's bond traders in New York are told to conduct the open-market operations necessary to hit that target. These open-market operations change the money supply and shift the LM curve so that the equilibrium interest rate (determined by the intersection of the IS and LM curves) equals the target interest rate that the Federal Open Market Committee has chosen.

As a result of this operating procedure, Fed policy is often discussed in terms of changing interest rates. Keep in mind, however, that behind these changes in interest rates are the necessary changes in the money supply. A newspaper might report, for instance, that "the Fed has lowered interest rates." To be more precise, we can translate this statement as meaning "the Federal Open Market Committee has instructed the Fed bond traders to buy bonds in open-market operations so as to increase the money supply, shift the LM curve, and reduce the equilibrium interest rate to hit a new lower target."

Why has the Fed chosen to use an interest rate, rather than the money supply, as its short-term policy instrument? One possible answer is that shocks to the LM curve are more prevalent than shocks to the IS curve. When the Fed targets interest rates, it automatically offsets LM shocks by adjusting the money supply, although this policy exacerbates IS shocks. If LM shocks are the more prevalent type, then a policy of targeting the interest rate leads to greater economic stability than a policy of targeting the money supply. (Problem 7 at the end of this chapter asks you to analyze this issue more fully.)

Another possible reason for using the interest rate as the short-term policy instrument is that interest rates are easier to measure than the money supply. As we saw in Chapter 4, the Fed has several different measures of money--M1, M2, and so on--which sometimes move in different directions. Rather than deciding which measure is best, the Fed avoids the question by using the federal funds rate as its policy instrument.

----[end of excerpt]

My email correspondent wonders whether it would be better just to jettison the traditional IS-LM model in favor of an alternative framework that ignores the money supply altogether and simply takes an interest-rate rule as given. This approach has been advocated by my old friend David Romer. (Economics trivia fact: I was the best man at David Romer's wedding, and he at mine.) You can find David's approach here (figures here). David calls his alternative presentation the IS-MP model, because it combines an IS curve with a monetary policy reaction function.

The first thing to understand about the choice between IS-LM and IS-MP is that it is not about determining which is the better model of short-run fluctuations. There is no truly substantive debate here. These two models are alternative presentations of the same set of ideas. The key issue in deciding which approach to prefer is not theoretical or empirical but pedagogical.

The IS-LM approach has a long history behind it. That is one reason to stick with it, but it is not dispositive. If I were convinced that the IS-MP model was a clear and substantial step forward, I would switch. So far, however, I am not convinced that the new approach is easier to teach or more intuitive for students.

The key difference between the two approaches is what you hold constant when considering various hypothetical policy experiments. The IS-LM model takes the money supply as the exogenous variable, while the IS-MP model takes the monetary policy reaction function as exogenous. In practice, both the money supply and the monetary policy reaction function can and do change in response to events. Exogeneity here is meant to be more of a thought experiment than it is a claim about the world. The two approaches focus the student's attention on different sets of thought experiments.

I like the IS-LM model because it keeps the student focused on the important connections between the money supply, interest rates, and economic activity, whereas the IS-MP model leaves some of that in the background. The IS-MP model also has some quirky features: In this model, for instance, an increase in government purchases causes a permanent increase in the inflation rate. No one really believes that result as an empirical prediction, for the simple reason that the monetary policy reaction function would change if the natural interest rate (that is, the real interest rate consistent with full employment) changed. This observation highlights that neither model's exogeneity assumption should be taken too seriously.

In the end, I remain open-minded, but at this point I prefer the IS-LM model when teaching (at the intermediate level) about the short-run effects of monetary and fiscal policy. If one were to teach IS-MP to undergrads, I would prefer to do it as an supplement, rather than a substitute, for IS-LM.

Related link: Here (and here in published form) is Paul Krugman's cogent defense of teaching the IS-LM model. The article was written quite a while ago, before IS-MP hit the scene, so I don't know what he would say about this alternative framework. But the Krugman piece is interesting, if only vaguely on point, so I wanted to give it some free advertising.