Among other reasons I’ve mentioned about why inflation targeting is a bad idea over the years here on my blog, I am once again pointing out a paper by David Beckworth that, in a nutshell, does a pretty good job of highlighting the obvious: The FOMC is blind in supply/productivity shocks.
Another set of observers questioned whether inflation targeting itself needed to be reconsidered. These individuals began wondering if an environment of price stability was the primordial soup from which emerged financial instability. They noted that positive supply shocks, which were abundant during this time, created problems for central banks that targeted inflation. On the one hand, the positive supply shocks coming from technology gains and the opening up of Asia meant more robust economic growth. On the other hand, the positive supply shocks meant sustained, downward pressure on inflation that, if not offset, would push inflation below its target. Central banks could prevent the too-low inflation by lowering their policy interest rates. This response, however, had the potential to further fuel the supply-side driven recovery and cause the economy to grow too fast. These developments, in turn, might create excess optimism, lower risk premiums, and spark increased leverage by firms and households. In short, large and frequent supply shocks can be a real challenge for inflation-targeting central banks. According to some, this was the backstory to the financial-sector boom leading up to the Great Recession.
…Despite these accomplishments, the above studies note that the success of inflation targeting depends on supply shocks being few and small. Supply shocks come from fundamental changes to economy. The introduction of a new technology that lowers firms’ per-unit production costs or a sudden reduction in the supply of an important input like oil are examples of supply shocks. These shocks create problems for monetary policy because they push real GDP and the price level in opposite directions. A technology innovation, for example, would tempt an inflation targeting central bank to ease monetary policy, because the resulting productivity gains would lower costs and put downward pressure on output prices. Doing so, however, may add excessive monetary stimulus to the technology-driven economic gains and create an unsustainable economic boom. Alternatively, a sudden reduction in the global supply of oil would raise output prices and might tempt a central bank to tighten monetary policy. Tightening, though, would inflict even more harm on an economy already weakened by the reduction in the oil supply.
The blindness is all over recent FOMC statements. For at least a year now, each statement contains something like the following: ‘We can’t tell what we’re doing with the oil supply shock. But we think it’s transitory and that inflation will make a comeback soon.’
But of course they can’t see what they’re doing with their core target masked by at least one supply shock, and so justification of a series of rate hikes is rather scant. It really is tempting fate. Just like in the Sept. 2008 meeting, inflation could be headed up or it could be headed down… Round and round she goes, where she stops nobody knows. Unfortunately, they can’t just bet on each red and black and walk away winners regretless of the outcome unless they had just left well enough alone, waiting to see how it shakes out.
I think, however, that with other “tools” to see what the economy is doing, like NGDP, they could tell that they have probably done the wrong thing in hiking rates, while the rest of us will end up seeing red.
For a FOMC that can’t wait, inflation targeting, regardless of how they do it, flexible or not, is not very practical explicitly because of this blindness problem. It’s been said that NGDP has a measurement problem, but what is this trying for over a year to see where they are going in the middle of one whopper of a supply shock??
I am sure that they intend to do the right thing for everyone involved. So why not choose a more definitive guide in NGDP measures, it’s been flashing the tight money warning for at least the last half of the year, rather than gambling on the reading of tea leaves? The latter has got to be the most explicit example of voodoo economics I’ve ever seen, and it isn’t fit for the large, technically advanced and dynamic economy we have.
Please, Ms. Yellen. Can monetary policy exit the Stone Age now?