Ideas & Central Banks

Via Brad DeLong a very important NBER working paper by Larry Ball (link). Essentially the paper discusses how Bernanke went from being one of the strongest proponents of inflation targeting, given his extensive knowledge of the Japanese liquidity trap, to a strong opponent of this policy when in power as the Fed chairman.

Bernanke once advocated a 3-4% inflation target for Japan;
as Fed chair, he says “that’s not a direction that we’re interested in pursuing.” Bernanke has also
abandoned his early proposals for currency depreciation and for money-financed tax cuts. More
generally, he no longer argues that a central bank can easily overcome the zero-bound problem “if
the will to do so exists.”

Given the growing movement towards a nominal GDP targeting and the heated discussions regarding policy options in a liquidity trap, this clear shift in the policy stance of a very central player is critical. Any central bank sets long-run interest rates by shaping expectations of future policy. This is fundamentally a choice of signalling and communication. It is a choice which depends crucially on the economic models employed by their economists, and on prevailing tendencies in economic debates. Inherent in an inflation or NGDP target is an apolitical rule which would yield a much more stable macroeconomy than the one we see today. How high should the inflation rate target be in this new rule?

Greg Mankiw(link) hints at a possible numerical explanation of the current real interest rate that would yield full employment. We have previously linked to Paul Krugman’s very succinct summaries of this problem, see here for instance. An optimal inflation target needs to take the current liquidity trap into consideration. Oliver Blanchard has argued strongly for higher inflation and other economists within the IMF have defended this view strongly, often coming from the same framework as Bernanke, as in this article. They arrive at the same inflation target – around 4%. Bernanke’s shift is therefore even more significant given the support from the usually conservative IMF for an explicit inflation targeting rule at a higher permitted inflation rate than the one currently pursued by Western central banks. Going further would be the NGDP target, which found strong support in an important paper by Goldman Sachs last year. One central conclusion of this paper follows:

Simulations using a highly simplified model suggest that a nominal GDP target could improve economic performance substantially compared with a standard Taylor rule. In the model, the economy receives a significant boost through lower real long-term interest rates, via a delay of the first funds rate hike and temporarily higher expected inflation.

Source: Goldman Sachs Global ECS US Research

One benefit of the NGDP target is the very clear and uncontroversial measure of the economy as opposed to choosing a proper deflator or attempting to define the output gap, which has led to some discussions in the blogosphere over the last week.

In a political climate where “uncertainty” is the enemy for many hard-money hawks in central banks and in the broader policy debate, this is even more unfortunate. The benefit of a new version of the Taylor rule is the substitution of an institutional rule for shifting Fed bargaining power and leadership. Not every chairman for every central bank can have the bargaining power or economic climate that allowed for the Volcker disinflation. Matt Yglesias puts this personal incentives argument very succintly:

A central banker who implements those ideas would run the risk of needing to take responsibility for failure in the event that something bad happens. Opting for the fudge that constituted conventional wisdom from the fall of 2008 through to the subsequent winter got Bernanke hailed as Person of the Year despite the economy collapsing all around him.

John Ruggie famously subscribed to the view of an international regime as one in which the expectations of actors converged upon a specific set of outcomes. The obvious political co-option of the Fed during the economic crisis has led to the QE programs, and the very aggressive monetary goals going forward. It also allowed for the low interest rates leading up to the crisis. Thereby the convergence of expectations becomes a political rather than an economic judgment, and creates clear time inconsistencies in Fed behavior. Rule-based NGDP targeting in particular would allow for an apolitical and legitimate conduction of monetary policy in the United States, clearly aligned towards the dual mandate.

Given the current discourse of politicians and the increased transparency of Fed decisions and communications, this would grant a much-needed frame of reference for central bank governors and chairmen, one that is more open towards a broader field of stakeholders and that is more properly connected to the views of other major institutions. This does not mean that asset price inflation should not be a focus going forward, but implementing a pragmatic target based on output/inflation gets us a long way. And of course, let’s not even get started on the help it could grant the ECB in its organizational environment, since it is extremely unlikely that we will ever see the ECB making the strong commitments necessary to positively shape expectations given its narrow mandate.