Scott Sumner  

Congress sets the goals, the Fed sets the intermediate target

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Over at TheMoneyIllusion I have a long post discussing Ben Bernanke's recent comments on monetary reform. There is one issue that seems especially important, and I wanted to devote an entire post to the subject. Here's Bernanke:

I want to raise a few practical concerns about the feasibility of changing the FOMC's target, at least in the near term. First, whatever its strengths and weaknesses, the current policy framework, with its two explicit targets and balanced approach, has the advantage of being closely and transparently connected to the Fed's mandate from Congress to promote price stability and maximum employment. It may be that having the Fed target other variables could lead to better results, but the linkages are complex and indirect, and there would be times when the pursuit of an alternative intermediate target might appear inconsistent with the mandate. For example, any of the leading alternative approaches could involve the Fed aiming for a relatively high inflation rate at times. Explaining the consistency of that with the statutory objective of price stability would be a communications challenge, and concerns about the public or congressional reaction would reduce the credibility of the FOMC's commitment to the alternative target.

Second, proponents of alternative targets have to accept the fact that, for better or worse, we are not starting with a blank slate. For several decades now, the Fed and other central banks have worked to anchor inflation expectations in the vicinity of 2 percent and to explain the associated policy approach. A change in target would face the hurdles of re-anchoring expectations and re-establishing long-term credibility, even though the very fact that the target is being changed could sow some doubts. At a minimum, Congress would have to be consulted and broad buy-in would have to be achieved.


This is obviously a very difficult subject, and there is clearly no single right answer. And yet I sometimes feel that people confuse mandates and targets, so I'd like to offer a few perspectives that might be useful. Let's start with the original intent:

1. The Fed's mandate was enacted by Congress in 1977, and includes both "reasonable price stability" and maximum employment. I think it's fair to say that 1977 was pretty close to the nadir of our understanding of monetary economics. I doubt one Congressman in 10 would have seriously thought the Fed could target inflation at say 2%. They would have been thrilled with 4% inflation. There is even a third mandate for low long-term interest rates, which is (rightfully) ignored.

2. On the other hand things change, and we now have a much better understanding of monetary economics. It's probably reasonable to assume that the Congress of 2015, and the public as well, would prefer that we do not return to 4% inflation. Nonetheless, the 1977 law is pretty vague, and I'd argue that today a 4% NGDP target is just as compatible with "reasonable price stability" and "maximum employment" as a 2% inflation target.

Many of my friends criticize the dual mandate because the Fed can only target one variable at a time. I used to feel the same way, but now I'm slightly more forgiving of Congress. I think the dual mandate could be regarded as sort of aspirational---the Congress telling the Fed to do the best it can in producing a stable economy with something close to price stability and high employment. But again, given that the law was passed in 1977, it's hard to believe that Congress envisioned they were instructing the Fed to hit any sort of single rigid inflation target, no one except a few monetarists would have even thought that possible in 1977.

Instead Congress was probably saying something like, "The Fed is one of many policymakers, we'd like them to do their part in contributing to good inflation and employment outcomes." Or perhaps Congress was saying, "Here are our goals, you figure out the best way to achieve them." If Fed officials think NGDP targeting is the most effective way to stabilize the economy, I think they already have all the authority they need under the very vague 1977 law. The only concession I'd make is that while I prefer a pure NGDP target which lets long term inflation fluctuate inversely to changes in long term RGDP growth, as a practical matter Congress does clearly care more about inflation than I do. Thus the actual target would probably be something like the Fed's estimate of trend RGDP, plus 2%, where the trend gets re-estimated every 5 years. That allows some inflation variation, but not much.

Some readers of this post might feel I'm granting the Fed far too much discretion. If so, I'd encourage you to re-read my earlier post on Fed accountability. I think it's reasonable for Congress to let the Fed determine how best to carry out the mandate, but then they should insist that the Fed clearly spells out its intermediate targets in such a way that monetary policy is clearly accountable, where we can say after the fact that the Fed did or did not hit its policy targets. In that respect, NGDP targeting is a vast improvement over the vague "2% inflation plus unemployment close to the natural rate" approach used in recent years. Under that approach it looks (to me) like monetary policy was clearly far too tight in 2008-13, and yet the Fed refuses to say that policy was much too tight, nor do they tell us why they don't think it was too tight.

So by all means keep the dual mandate, but have the Fed move from two targets to one, so that the spotlight shines more clearly on their policy. Institutions that are highly accountable will do better, even if the managers are already very civic-minded. That's because the accountability would make it easier for the Fed to take the tough decisions in periods like 2008-09 that it should have taken, but perhaps held back due to fears of provoking controversy. Under an ideal regime you want the Fed to be able to say, "Look, this is our mandate, we'll do whatever it takes to hit the mandate."

I'm not an expert on Congress, but I would think that the Fed would want explicit Congressional authorization for a major policy change such as raising the inflation target to 4%. That's not price stability. But as for a NGDP intermediate target that was consistent with expected 2% inflation, Fed consultation with Congress should be sufficient.


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COMMENTS (15 to date)
ThomasH writes:

As an intermediate step, how about having the Fed set an inflation target, not a target for maximum inflation. That way if inflation is below target one quarter, the market would know that the Fed would be trying to push it (especially if the unemployment rate was above target) up and vice versa. I think Krugman once called this making a "Commitment to "Irresponsible" Behavior."

Bernanke is no doubt right that central banks have worked hard to anchor inflationary expectations around something less than 2% but with a little more work they could anchor them AT 2%, or any other number they choose.

Scott Sumner writes:

Thomas, The Fed has already done this, they just act like it's a ceiling. Their inflation target is symmetric.

Capt. J Parker writes:

If I understand NGDPLT, the FED would attempt to keep NGDP moving along a prescribed growth path as opposed to just trying to target the rate of change of NDGP. If the Fed adopted price level targeting, would this be a step in the right direction? If the growth path target was a 2% annual growth in prices (which doesn't get offset downward if the Fed fails to stay on the path in any given year) does this really suffer from Bernanke's criticism that very expansionary monetary policy in a down economy undertaken to get back to the target path for prices is inconsistent with stable prices? If it dose suffer from that criticism then I think two other things are true.
1) Bernanke believes people don't really trust central banks' ability to target prices.
2) Bernanke believes anchoring inflation expectations is more important than trying to coordinate monetary policy with any fiscal stimulus congress provides.

dajeeps writes:

This is a great post on a hypothetical arrangement with Congress. I agree with it, but can’t help being cynical. The conversation with Congress all depends on framing. And right now, it appears to me that those at the Fed involved in conversations with Congress are neither willing to offer something other than discretionary policy, a more delicate way of stating a preference for arbitrary and capricious, nor are they prepared to accept elements of recent policy errors that highlight the need for accountability. Most are in an entirely other world above the law, where unicorns bring the inflation rate back to two percent in the next year or two; and because the economy may be able to withstand a rate hike, it’s an ay-okay thing to do – all with a reverse repo tool that they don’t fully understand and is far more likely to err on the side of tight.

I commend your inclination toward optimism and willingness to extend ample amounts of charity toward people who probably don’t deserve it. You are a far better person for it than I could ever be.

Bill Woolsey writes:

Captain Parker:

Price level stability is very bad when there is an aggregate supply shock. If the price of oil rises, the Fed would push an already weak economy into a deeper recession to force down other prices and wages so that the price level returns to target.

An inflation target allows the Fed to allow the increase in the price level and just try to prevent further increases.

A nominal GDP level target allows aggregate supply shocks to raise the price level.

Both a nominal GDP level target and a price level target provide better bounce back after a recession. But the price level target has, in my view, unacceptable disadvantages when there is a supply shock.

Michael Byrnes writes:

The Fed's flexibility in targeting inflation is, at least in theory, a way to avoid the negative consequences of a price level target.

But in practice it is a procyclical policy that allows the Fed to duck accountability. They are holding inflation below 2% now in part because they expect more inflationary pressure later. Maybe when we look back in 20 years we will find that they were "right", that the long term price level trend is 2% inflation. But for that to be true it would mean that the Fed allowed inflation to be unacceptably low during a crisis and then "made up for it" by lessing prices rise during a boom.

Shayne Cook writes:

Bill Woolsey:

I couldn't read Captain Parker's comment - It had already been removed before I saw this post and your comment. So I may be reading too much into your response to Parker, but it indicated something interesting.

You mention "aggregate supply shock", and then give the example of "If the price of oil rises ...". I think I understand the point you were trying to make (or maybe not). But relative to Fed actions and role in the U.S. economy, that example seems to be one of focusing on the impact of "one small ant in a room that contains at least one large elephant", if you'll pardon my metaphor.

Given that U.S. oil consumption is currently about 18.5 Million Bls/Day, that U.S. oil consumption represents less than 4% of NGDP even at $100 per barrel. At current prices, it represents at or less than 2% of NGDP. In other words, oil price levels, even across a very wide range, seem to represent a very small "ant" in a very large "room - that contains at least one very large elephant". The "elephant" I'm referring to here is U.S. health care financing - currently at about 18% to 19% of U.S. NGDP, and growing much faster (about 3X) than NGDP.

In context with the larger discussion of Fed actions/guidance/methods/targets, the "elephant" seems of more consequence than the "ant". In that larger context, NGDP (total spending) is, in all effects, the sum of both current incomes of all constituents of the economy, plus borrowings of all constituents of the economy. But the current construct for U.S. health care financing (feeding the "elephant") is solely and increasingly a diversion of current incomes - to only that sector of the economy.

That leaves the Fed in an extremely and increasingly precarious position, given its mandates, completely irrespective of what methodology, or "targets" it applies. As more and more of current incomes produced by the U.S. economy is (coercively) diverted to health care, there is of course, less and less current income available for all other sectors of the economy, or even for debt service on borrowings for that matter. The Fed can't do anything about that. In all respects, the Fed can only influence the "borrowings" contributions to NGDP, and that only relative to the non-health care sectors of the economy. The health care "elephant" is financed ("fed") from current incomes.

What precludes me from supporting NGDP level targeting, as opposed to price-level/inflation targeting on the part of the Fed, is that NGDP targeting hides mal-investment, and especially debt-financed mal-investment as well as debt-financed mal-consumption.

Consider the period from 2000 - 2008. The NGDP and NGDP growth metrics looked increasingly good during that period. In hindsight however, much, if not all of the good-looking NGDP/Growth in the later years of that period were the result of debt-financed mal-investment in housing.

To whatever extent the Fed erred, and contributed to/enabled debt-financed mal-investment during that period, it seemed to err based on relying far too heavily on the NGDP and NGDP Growth metrics of the day - as did everyone else. Indeed, when Alan Greenspan "apologized" for his (Fed) errors and contributions/enablings of the housing bubble, it was for having not looked closely enough at inflation in the housing sector, and instead relying far too heavily on NGDP data alone for feedback on Fed policy.

It strikes me that Fed policy will be less prone-to-error in the future if it responds to price-levels/inflations in an even more fine-grained (sector-by-sector) basis, rather than relying solely on the more aggregated NGDP metric. (And that, with full knowledge of the economic impacts of the "elephant" in the U.S. economy).

Am I missing something important?

Scott Sumner writes:

Capt. Parker, Your description of price level targeting is correct, and I don't think it would lead to excessive periods of inflation.

dajeeps, Thanks, but I doubt I'm a better person than you.

Bill, I agree.

Michael, Yes, the flexible inflation target is supposed to make inflation countercyclical, but instead it's procyclical.

Capt. J Parker writes:

Bill Woolsey,
Thanks for the response. I don't intend to argue against NGDPLT. But, If I read you right you are arguing that an adverse supply shock, in oil for example, will increase the overall price level. But why? I was led to believe Friedman argued that an oil price shock (like the 70's oil price shocks) will raise the price of oil but it must also lower the price of everything else as long as the money supply is stable.

ThomasH writes:

Sorry, I don't understand when you explain they [the Fed] just act like it's a ceiling. Their inflation target is symmetric. If the Fed "acts like" it is a ceiling, then people will (and I think do) assume that that they will not target a period of higher inflation to make up for periods of below target inflation.

Capt. J Parker writes:

Bill Woolsey,
Thanks for the response. I don't intend to argue against NGDPLT but, it seems to me you are arguing that an adverse supply shock, in oil for example, will increase the overall price level. But why? I was led to believe Friedman argued that an oil price shock (like the 70's oil price shocks) will raise the price of oil but it must also lower the price of everything else as long as the money supply is stable. (A consequence of Friedman's reasoning is the 70's inflation was everywhere a monetary phenomenon.)

Scott Sumner writes:

Thomas, There is no "make-up" with inflation targeting, each year they start fresh, and ignore previous overshoots or undershoots. My point is that the Fed already has an inflation target that they say is symmetrical.

W. Peden writes:

Capt. J Parker,

It depends whether or not the shock causes a permanent shift in real output. If it doesn't, then the price level is unchanged in equilibrium. If it does, then the price level (but not the rate of inflation) rises relative to its counterfactual level. So if we assume that M*V is constant, then a change in Q entails a change in P, but not all changes in Q affect the equilibrium value of Q, e.g. you can have an endogenous response to the rise of the price of oil that results in fracking etc. reducing the price and restoring output to the value it would have been if the oil shock had not occured.

jj writes:
It may be that having the Fed target other variables could lead to better results, but the linkages are complex and indirect, and there would be times when the pursuit of an alternative intermediate target might appear inconsistent with the mandate.

The current intermediate target, the fed funds rate, has complex and indirect linkages to inflation and employment.

Most people (e.g. Congress) wrongly think the linkage is simple and direct: high interest rates > lower inflation, higher unemployment.

Explaining the consistency of that with the statutory objective of price stability would be a communications challenge

It seems like Bernanke is saying "Congress may be totally wrong about how Fed moves affect the economy, but at least they think they know and that keeps them off our back."

any of the leading alternative approaches could involve the Fed aiming for a relatively high inflation rate at times.

As would the current intermediate interest rate target, if it were used properly to achieve the congressional mandate.

Capt. J Parker writes:

W. Peden,
Thanks. On reflection I'm sure you and Mr. Woolsey are right that adverse supply shocks do increase the aggregate price level in the short run even if there is a tenancy for them to return to their original equilibrium level in the longer run.

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