A recent Scott Sumner post on monetary policy formation gave me an idea to make a post about sacred cow economic theories and policies.
For this post, I will be focusing on by far the most damaging sacred cow: inflation targeting or related price-based monetary policy management. These are obsolete and unworkable in many ways, and here are just a few:
- Supply shocks need to be ignored. The problem here is that some supply shocks are harder to identify than others. Oil or energy-based supply shocks are pretty obvious. But what about a trend in labor importation, such as a shift toward dumping employees with US passports for those with NAFTA visas? The problem presented would have to do with understanding when or whether this trend impacts inflation and disentangling the impact from aggregate inflation measures. And of course someone in government would not only have to recognize such a trend and be able to make judgements based on evidence, but would also have be able to admit the magnitude of it in order for any of this to be comprehended by monetary policy. The political system simply wouldn’t tolerate a Fed economist to be so bold, so good luck with that.
- Commodities markets turn domestic monetary management into a global zero sum issue for price-based targets. Economies running hotter in other parts of the world mean others running cooler in the short to medium term with global commodities markets as a price transmission mechanism and the complexities involved in price to domestic economic activity disentanglement. Good luck with that also.
- One might think that my point numbers one and two are connected. They are indeed two different points of the same overall problem of price changes not necessarily being reflective of domestic nominal conditions. These and other similar points are why the Bernanke Fed failed to appropriately manage the late 2000’s oil supply shocks, and why the Yellen Fed can’t seem to figure out why expected inflation failed to materialize and has ultimately wasted four years doing the wrong things. It is a feat of epic proportions to be able to identify all of the needed band aids and exceptions required for IT to be successful because it is not inherently compatible with globally connected economies and doesn’t come with an instruction booklet. With that said, stuff is going to happen in big ways out in the wilds that the smart people in room won’t understand in specificity until after the oversight has caused economic damage – and given the recent performance of central banks in noticing the nature of their mistakes and correcting them, to say that mistake X, and all of the other potential mistakes yet to materialize, won’t ever happen again is nothing short of unrealistic.
Inflation targeting is also problematic politically. I can concede that Bernanke may have personally recognized the mistakes made in 2008 and tried to convince the others to do what needed to be done – adopt much more expansionary policy – resulting in open season on the Fed politically that made doing the right things much more difficult and time consuming. The inability to deploy a remedy for mistakes that have a high probability of occurring under IT makes it unworkable. We simply cannot allow the house to burn down because of our own ignorance, and government does a grave disservice to the public for allowing it.
It’s a sad thing that IT is such a sacred cow when there are less error prone and likely more politically acceptable ways of managing monetary policy, such as NGDP level targeting. Maybe someday we will be able to get rid of it, but as sacred cows go, I am not holding my breath.