Strategic Briefing – Debating Monetary Policy (Still)

Fed’s Lacker Says Operation Twist Won’t Help Growth, Jobs
Bloomberg | June 22
Federal Reserve Bank of Richmond President Jeffrey Lacker said he dissented from the Fed’s $267 billion extension of its Operation Twist program believing it would spur inflation and not significantly help the economy. “I do not believe that further monetary stimulus would make a substantial difference for economic growth and employment without increasing inflation by more than would be desirable,” Lacker said in a statement today from the Richmond Fed.

What the press should ask Bernanke
Scott Sumner (The Money Illusion) | June 21
Bernanke likes to say monetary policy is “not a panacea.” In one sense that’s true, but it most certainly is a panacea for inadequate NGDP growth, and all the associated problems that flow from inadequate NGDP, such as above natural rate unemployment and that part of financial/banking distress that flows from falling nominal incomes.

Monetary Policy Is about Money, not Interest Rates
Tim Lee (Forbes) | June 20
And when tight money has produced ultra-low interest rates, then thinking about monetary policy in terms of interest rates is misleading. Obviously, it seems unlikely that pushing long-term interest rates even closer to zero will have a big effect on business investment. But the point of monetary easing isn’t lower interest rates, it’s giving people more money to spend.
Indeed, effective monetary easing will likely lead to a rise in interest rates, as businesses anticipate consumers with more money in their pockets will buy more goods and services. That will lead to a virtuous circle: businesses hire more workers in anticipation of increased demand, which puts more money in workers’ pockets, who then spend their earnings on goods and services, further increasing demand. But the idea that the Fed conducts monetary policy by manipulating interest rates makes it impossible to think about this process clearly.

The death of Inflation Targeting
Jeffrey Frankel (Vox) | June 19
The current economic crisis has called into question the role of monetary policy, particularly Inflation Targeting and its oversight of asset bubbles and supply side shocks. This column is an obituary to Inflation Targeting and call for Nominal GDP Targeting to replace it….

Fans of Nominal GDP Targeting point out that it would not, like Inflation Targeting, have the problem of excessive tightening in response to adverse supply shocks. Nominal GDP Targeting stabilises demand, which is really all that can be asked of monetary policy. An adverse supply shock is automatically divided between inflation and real GDP, equally, which is pretty much what a central bank with discretion would do anyway.
In the long term, the advantage of a regime that targets nominal GDP is that it is more robust with respect to shocks than the competitors (gold standard, money target, exchange rate target, or CPI target). But why has it suddenly gained popularity at this point in history, after two decades of living in obscurity? Nominal GDP Targeting might also have another advantage in the current unfortunate economic situation that afflicts much of the world: Its proponents see it as a way of achieving a monetary expansion that is much-needed at the current juncture.

“Inflation Targeting is Dead”
Mark Thoma (Economist’s View) | June 14
It’s hard to figure out how to fix the world if you don’t have a reliable model that can explain what went wrong. The optimal money rule in a model depends upon the the way in which changes in monetary policy are transmitted to the real economy. Is it because of price rigidities? Wage rigidities? Information problems? Credit frictions and rationing? The best response to a negative shock to the economy varies depending upon what type of model the investigator is using.

Thus, for the moment we need robust rules. Inflation targeting works well in models with Calvo type price-rigidities, and a Taylor type rule often emerges from models in this general class, but is this the most robust rule in the face of model uncertainty? We don’t know the true model of the macroeconomy, that ought to be clear at this point. Does inflation targeting work well when the underlying problem is a breakdown in financial intermediation or other big problems in the financial sector? I’m not at all convinced that it does – some of the best remedies in this case involve abandoning a strict adherence to an inflation target in the short-run.

So, in the best of all worlds I’d prefer to have a model of the economy that works, find the optimal policy rule for that model, and then execute it. In the world we live in, I want robust rules — rules that work well in a variety of models and in the face of a variety of different types of shocks (or at least recognize that the rule has to change when the source of the problem switches from, say, price rigidities to a breakdown in financial intermediation). One message that comes out of the description of NGDP targeting above is that this approach does appear to be more robust than inflation targeting. It’s not always better, in some models a standard Taylor type rule is the best that can be done. But it’s becoming harder and harder to believe that the Great Recession can be adequately described by models of this type, and hence hard to believe that we are well served by policy rules that assume price rigidities are the main source of economic fluctuations.

This post originally appeared at The Capital Spectator and is posted with permission.