Noah Smith has an opinion piece in Bloomberg that is a few weeks old, discussing the impact of an irrational fear of inflation on monetary policy. While distracted with other issues, I was hoping another MM blogger would address it. But I haven’t seen anything about it, so I will go ahead and engage.

It is an absolutely fabulous development that Smith has apparently joined the still emerging consensus that the short nominal interest rate does not need to be hiked, and the Fed likely needs a new target to avoid inflicting economic damage. I also have accolades of affection for Smith’s opening argument regarding an irrational fear of inflation that has arguably lead to equally irrational monetary policy choices.

Unfortunately, as indicated by certain passages in Smith’s article, we still have our work cut out for us in further shaping consensus on the best path forward for monetary policy. Here is a specific example:

Many people seem to think that inflation and recession are equal, symmetric dangers. This is implicit in the idea of nominal GDP (NGDP) targeting, which is promoted by economists like Scott Sumner at George Mason University’s Mercatus Institute. Since NGDP growth is just the sum of real GDP growth and inflation, Sumner’s policy implies that one percentage point of higher inflation is in some sense just as bad as a one-point reduction in growth. But in reality, a loss of one percentage point of GDP probably is many times worse than a 1 percent rise in inflation.

Here, it appears that Smith misunderstands the “NGDP targeting” argument in at least two ways.

  • Many of us in the “NGDP targeting” movement don’t actually support NGDP targeting. Rather, we support NGDP level targeting with the aid of a futures market which is more about expectations management than it is about math and measurements, as opposed to strait up NGDP targeting. The basic premise is that if NGDP growth is stable with an explicit promise to be kept stable, the business cycle will become smoothed. Further, we desire smoothing of the business cycle, because fluctuations in the business cycle are the essence of negative impact to economic well being. Inflation targeting is about smoothing price changes while the business cycle is left to wander about, causing unpredictability and potential exacerbation in price swings (yes, I am making the claim that smoothing prices instead of the business cycle does not produce economic certainty or stability).
  • Because Smith appears to misunderstand the arguments of NGDPLT proponents, he ends up mischaracterizing their assumptions as holding to a principle that inflation is injurious in any sense. I can speak only for myself, but inflation is a concept that is rather fluid in definition, and is impacted by many factors aside from those monetary in nature. Consequently, it is difficult to arrive at a consensus measure that would be appropriate for the purposes of monetary policy. Moreover, if we can’t adequately define or measure inflation for purposes of monetary policy, it is difficult to form any rational characterization in regard it its affects either way (never reason from a price change), with the exception of claiming that we’re more likely than not to run into problems if we use the concept of inflation as a basis for monetary policy. Furthermore, inflation targeting itself has the potential to be far more injurious than any rise in inflation, as Smith claims, even one percentage point. Suppose what might happen in the current monetary environment if inflation rose by one percentage point, and think about whether it would produce a good outcome.

But of course, Smith has an answer for my thought experiment:

But economic research says that this probably isn’t the best approach for the Fed. As long as inflation can be kept from fluctuating wildly, or from spiraling upward into uncontrollable hyperinflation, the big worry should be about real growth. That means that the Fed probably shouldn’t be afraid of a higher inflation target, if that meant getting more people back into the ranks of the employed.

It’s interesting that there are no links to the research that says NGDP targeting “probably isn’t the best approach for the Fed.” I would be interested in reading it to see if I’ve missed important concepts in forming my priors. Obviously, I disagree that raising the inflation target is a real solution to all of the problems I outlined in my bullet points above. Though, I do believe, it could produce a better outcome than a lower inflation target has simply by being more forgiving of policy mistakes, with limits, of course.