I found an interesting blog post by Thomas Palley from 2007 objecting to explicit inflation targeting. I can’t say that he presented a very good argument in this post, at least not one as well reasoned as Rao Aiyagari’s paper; and certainly not as thorough as other economist-bloggers like Sumner, Nunes and Christensen after the fact. It is a holistic but simplistic argument that I can understand, that basically says that adopting explicit inflation targeting would disrupt the wage-led economy, transforming it to a profit-led economy.

What I find interesting about the post is one of the comments by a supposed Fed economist named “Mark” that translated the concerns raised by Palley into an argument about raising the funds rate at inappropriate times. And here is what it says:

…The thrust of Palley’s comments is that he wishes to avoid the pain of Keynesian funds rate hikes, meaning the higher unemployment they would bring, and to do so he is willing to argue that higher inflation may actually be a good thing. He is right to object to higher funds rates and higher unemployment. He is wrong to think higher inflation will be good for economic growth or employment; that would bring stagflation again.

As to whether inflation affects economic growth, classical analysis indicates that it most certainly does, and that the effects are negative. In summary, inflation is a deterioration of the quality of the currency because the change in value requires repricing of all goods, services and assets priced in the currency. In the absence of accurate repricing, value or marketability will be lost. With trillions of items to be repriced with each change of currency value, this is very burdensome. When the changes are secret or hard to measure, or unpredictable, uncertainties arise that greatly increase the risk and impede the process of capital investment

The best outcome for employment, economic growth and inflation is provided by Fed policy targeting stable value for the dollar. That eliminates inflation entirely, and allows labor to compete for higher wages whenever labor or skills are in short supply in a growing economy, without the Fed dampening the opportunity on every occasion. In a non-inflationary economy, wages give important signals to producers and workers, just like prices do…

I wonder why, with the argument concerning the eradication of inflation everywhere, the fallback claim is a condition that is either black or white. We either have zero inflation or we get 1970’s style “stagflation.” But historical economic performance suggests otherwise. That is why so many people have to point to the 1970’s as the poster child for out-of-control-inflation while the idea of being obsessed about inflation is old, but a rather new development in contemporary application to US monetary policy, with a brief exception of the Volker Fed.

What puts this argument by the commenter on the edge of absurdity is that it’s bolstered by the menu cost of inflation argument, as if hiking the FF rate at inappropriate times does not also entail re-pricing of items. In addition, it assumes that reducing the supposed drag from re-pricing is enough of a return to keep the economy growing whilst the FF rate and thus unemployment are too high, as in occasions of supply-side inflation such that were occurring when Palley posted his argument.

Menu costs isn’t an anti-inflation argument, but is constantly taken for granted as such. It is a nominal stability argument because menu costs are incurred only when present monetary conditions are unexpected, such as unexpected inflation AND deflation. Nominal stability has little to do with the exchange rate, but everything to do with stable expectations, maintaining conditions that can be planned for. Thus one can have 2% or 3% or even 10% inflation and menu costs aren’t an issue as long as the rate is consistent and expected to occur. Simply put, the menu cost argument applies when the Fed does something unexpected, which under an ill-defined inflation targeting regime is likely because it is prone to hike the FF rate during bouts of supply side inflation, for example, among other mishaps that occur when reasoning from a price change. And if the target inflation rate is too low, the probability of deflation and hitting the ZLB is higher than if the target inflation rate were higher because the lower the target, the more condensed the margin of rectifiable error.

They key to a successful inflation targeting regime, if there could ever be one not confused by supply side issues, would be to express the target in a band, and to have a symmetrical target to help stabilize expectations. It would be the only way to avoid menu costs in either direction and reduce the impact of unmet expectations in other areas such as employment.

Lastly, the commenter suggested that the higher the inflation target, the harder inflation is to control. And again, the control issue comes from lack of nominal stability – the inability to meet set expectations. In the scenario of oil supply issues that arise suddenly, it is impossible for an inflation targeting regime to maintain set expectations without causing economic harm. Also, I suppose one would have to accept that controlling inflation is justifiable in economic terms and desirable above other approaches to maintaining nominal stability in order to assume that the point of controlling inflation has merit.

I don’t accept that controlling inflation is the best approach because menu costs (if there is such a creature in a stable monetary regime) do not justify economic damage incurred from inappropriately adjusting the FF rate, being that there are sources of inflation that have nothing to do with monetary policy. No one, as of yet, has been able to disentangle price changes that are the result of monetary policy in excess from those that aren’t. Thus the whole concept is error prone. I’d also add that market panics are also hard to control once they get started, and deflation is harder to control, taking politically controversial, extraordinary measures to contain and recover from; exactly the sort of situation that happened a year after Palley made this argument.

In summary:

  • The rate of inflation targeted is not connected to menu costs.
  • Menu costs are associated with unexpected inflation or deflation, either one, that can have either monetary or supply side causes, and therefore cannot be entirely controlled with monetary policy without causing economic damage by inappropriately adjusting policy based solely on movements in prices.
  • Inflation, generally a supply/demand phenomenon even existing in barter economies, is a pesky fact of life and one should question the value to society as a whole in using monetary policy to control it; especially if the argument is supported by flimsy, unquantified evidence of attempting to repeal menu costs associated with it, and does not account for the economic costs of monetary policy that suddenly becomes too tight.
  • Inappropriate adjustment of monetary policy produces unexpected changes in inflation, the very nature of nominal instability, thus produces the menu costs inflation targeting proponents are attempting to avoid, in addition to other costs related – high unemployment and defaults.

I’ve digressed to rehashing old arguments which really wasn’t my original intent. My original intent was to point out the intellectual bravery displayed by Palley in swimming against the inflation-targeting current when it mattered, back in 2007. It surely isn’t his fault his attempt to prevent an economic calamity failed. He isn’t now a market monetarist, but his effort deserves a very belated applause.

In my office, in my group of IT engineers, we have a saying. We can fix technical issues, but we can’t fix stupid – and that just about sums up the atmosphere in the economics profession in the latter half of the last decade.

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