Scott Sumner  

The costs of inflation and recession

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Noah Smith has a good post on the costs of inflation and recession, but I don't quite agree with this:

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.
This claim confuses several unrelated issues:

1. Most of Smith's post focuses on the costs of higher or lower trend inflation. Once people get used to a 4% trend inflation rate, the cost is probably not much higher than an expected 2% inflation rate. But in the long run there is no trade-off between trend inflation and unemployment, with the possible exception of really low inflation rates, where the twin zero bounds on wage increases and nominal interest rates may create problems. Assuming you pick a high enough inflation/NGDP target to avoid these zero bound issues, there should be no further gains to higher inflation rates.

2. Smith's comments make more sense for inflation volatility. But even there I'd suggest a different interpretation. I do not favor NGDP targeting because I view inflation and recession as equally severe problems, rather I believe (rightly or wrongly) that a stable path for NGDP would be most likely to minimize the harmful impact of recessions (unstable employment and unstable financial markets) while continuing to allow real GDP fluctuations that are not harmful, say due to productivity fluctuations with non-monetary causes.

Now in fairness, NGDP is probably not precisely the optimal target for minimizing the welfare costs of employment instability and financial market instability in the US, but I think it's pretty close. In my previous post I suggested that in some cases, such as Ireland, it's not even very close to being optimal, at least for measured NGDP.

PS. Those familiar with New Keynesian models may recognize that I'm making a claim similar to the "divine coincidence" argument for inflation targeting, but applying the concept to NGDP targeting. The world's too messy for divine coincidences to work perfectly, but I believe that NGDP targeting comes pretty close, at least in the US and other major economies.


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COMMENTS (15 to date)
Lorenzo from Oz writes:

Isn't part of the appeal of NGDP targeting is that it provides a path for weaning those who confuse "hard" money with sound money to more concern for overall stability in employment growth?

Lorenzo from Oz writes:

I know from personal experience, that folk tend to fret that NGDP targeting would be "soft" on inflation. Apart from the problem you have remarked upon before -- people think of inflation as the prices they have to pay for things going up but not their incomes -- inflation has a role as a mark of disorder reaching into everyone's wallet that gives it negative associations well beyond it's actual implications. Particularly at the levels currently being considered.

James Alexander writes:

Lorenzo
I had just read your excellent post on how hard money creates unsound money while looking for something else.

The hard money guys fear our new Chancellor is about to go soft:
http://www.cps.org.uk/publications/factsheets/apocalypse-soon-the-danger-of-further-loosening-monetary-policy/

As you say the debate is between sound and unsound.

bill writes:

I thought Smith mischaracterized NGDP targeting in this way. If RGDP is low by 1% (bad), then keeping NGDP on track means higher inflation (in his article, higher inflation is also bad, just not nearly as bad as lower growth (I agree with that sub-point)).

James Alexander writes:

Lorenzo
I had just read your excellent post on how hard money creates unsound money while looking for something else.

The hard money guys fear our new Chancellor is about to go soft:
http://www.cps.org.uk/publications/factsheets/apocalypse-soon-the-danger-of-further-loosening-monetary-policy/

As you say the debate is between sound and unsound.

Dave Smith writes:

I agree with bill. I think Smith said exactly the opposite of what he meant to. His post would have been excellent if he would not have mentioned NGDP targeting.

Market Fiscalist writes:

Isn't Smith just plain wrong to say that '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'? Doesn't NGDP targeting rather imply that variations in the inflation rate are a price worth paying to avoid unnecessary reductions in growth that otherwise may be caused by demand-side factors ?

Scott Sumner writes:

Everyone, I think it's misleading to think in terms of "trade-offs" with NGDP targeting. If it works as planned, then both the changes in output and the changes in inflation will be optimal, not problems balanced against each other.

Of course in the real world it's not that optimal, but I think Smith completely missed that aspect of the argument.

Lorenzo, That's a common misconception. Inflation is no higher under inflation targeting than under NGDP targeting.

Lorenzo from Oz writes:

James Alexander: thanks.

Scott:

If it works as planned, then both the changes in output and the changes in inflation will be optimal, not problems balanced against each other.
That's a point that warrants explicit reiterating, even with the caveat.

That's a common misconception. Inflation is no higher under inflation targeting than under NGDP targeting.
Yep, very common. It is as if people think the inflation demon has to be specifically exorcised otherwise it will invade people's wallets.
Benjamin Cole writes:

Good post. Smith is not an economist or even an econo-pundit.

I do think there is a case to be made, especially today in the messy real world, for running the economy hot and seeing if we get any inflation.

The 1990s were fine and in the recent oil boom North Dakota and Texas did not have inflation above US average. Japan has tight labor markets and no inflation.

The Fed should print a lot of money.

Scott Sumner writes:

Thanks Lorenzo.

Ben, Actually Smith is an economist and a pundit.

James Alexander writes:

"Inflation is no higher under inflation targeting than under NGDP Targeting."

I'd expect inflation to be more stable under NGDP Targeting than Inflation Targeting, too.

bill writes:

I would have expected you to disagree more strongly with this quote from the Smith piece:

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.

bill writes:

I would have expected you to disagree more strongly with this quote from the Smith piece:

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.

James Alexander writes:

The best argument for NGDP growth targets over inflation targeting is that it encourages a healthy labor market.
https://thefaintofheart.wordpress.com/2016/07/17/what-a-healthy-us-labor-market-looks-like/#comments

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