Bryan Caplan  

Question for Scott

Please, don't experiment with ... Henderson and Furman on Kudlow...
Question inspired by Scott Sumner's latest post: Why not just let the inflation target rise to 3% to provide wiggle room for conventional monetary policy during future recessions?

Update: Read Scott's answer!

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COMMENTS (11 to date)
Scott Sumner writes:

That policy would certainly be better than the current policy regime.

Still better would be keeping the inflation target at 2%, but switching to a level targeting regime (as Bernanke recently proposed).

Even better would be a 4% NGDP level targeting regime.

Level targeting around roughly 2% inflation has two advantages:

1. Lower taxes on capital income, and hence more capital formation.

2. Helps preserve Fed credibility. They only recently made their 2% target official---changing to 3% would damage credibility. It's harder to do monetary policy effectively if you lose credibility.

Interestingly, the argument you most often hear against the 3% target is completely bogus. That argument claims "If the Fed can't hit its 2% target, what makes you think it would hit its 3% target?" But falling 0.3% short of the 3% target would still raise inflation by 1% relative to falling 0.3% short of its 2% target.

Again, if we aren't going to shift to level targeting, then the inflation target should be raised to 3%.

John M Hall writes:

Bryan's proposal is the opposite of what people are talking about when they usually are talking about monetary policy wiggle room. Lately people are saying that the Fed should raise rates now so that when we are in a recession in the future, we are able to reduce the rates. When I first read his question, I had just assumed he was referring to this argument, but that's really not what he's saying at all. Allowing the inflation target to rise to 3% in a recession or something would mean that the Fed would pre-commit to bring rates low faster during recessions and leave them there potentially longer (depending on the implementation).

I haven't really been able to follow the argument that we should raise rates faster so that we can lower them in a recession. The argument against it seems rather obvious from a natural rate perspective. From this perspective, low interest rates need not be that stimulative if the natural rate is also low. The spread matters more. Further, the natural rate is not controlled by the Fed. So if the natural rate remains low, then it doesn't matter if we raise rates now and then cut in a recession.

Scott Sumner writes:

Bryan, If we are going to do this changeover we should wait for the next recession before raising the inflation target to 3%.

John, Your second paragraph correctly explains why the commonly heard argument you cite is wrong. Raising rates now will reduce the natural rate, and actually give us less "ammo" in the next recession.

Jacob Egner writes:

Scott Sumner: is there a good place for me to read up on why you suggest 4% NGDP level targeting, rather than 1% or 16%? In fact, if there's some good resource that gently introduces me to the case for NGDP level targeting, I'd love to read that too. Thanks.

Mike H writes:

I second Jacob.

NGDP targeting to my naive mind seems to cap the level of economic growth and make deflation much more likely if we have an economic surge. Is this not true?

Effem writes:

Scott, i'm not mistaken when you first advocated a NGDP Targeting regime you advocated 6%, then at some point you started saying 5%, and now I see you consider 4% optimal. Seems to me like this is a giant flaw in NGDP targeting. I agree the price level is hard to measure...but I think productivity is even harder to measure. Had we instituted 6%, we would now be faced with a 2% higher implied inflation target relative to the currently optimal 4% NGDP Targeting approach.

Scott Sumner writes:

Jacob, Check this out:

A higher than 4% rate increases the welfare cost of inflation. A lower rate leads to more labor market inefficiency due to downward wage inflexibility. Thus 4% is a compromise, but other numbers like 3% or 5% would also work OK.

Mike, The first statement is false but the second statement is true. Don't confuse NGDP and RGDP.

Effem, You said:

"Scott, i'm not mistaken when you first advocated a NGDP Targeting regime you advocated 6%"

No, that's not true. I did originally advocate 5%, but that was only to make the changeover smoother. Before 2008, 5% was the trend rate of NGDP growth. In recent years the trend rate has been 4%, so that's what I'm advocating. Either figure would work fine.

Thomas Sewell writes:

@Jacob, Mike H,
As I understand it, that may be the effect if you were talking about real GDP, but nominal GDP being held steady is primarily to stabilize wage and price change expectations.

So real GDP could grow much more than 4%, it wouldn't act as a cap, you just wouldn't see nominal prices change as much as they would if NGDP was allowed to fluctuate more with RGDP, i.e. less inflation coming with higher growth.

Scott can probably explain it better, so you might start with . :)

Jacob Egner writes:

Scott Sumners, Thomas Sewell: Thanks! I'll be sure to give those a read.

Thomas Sewell: I've been a fan of your work for a long time. It's nice to see your comments on this blog.

Thomas Sewell writes:


Thanks, but you're probably thinking of the more famous similar named economist Thomas Sowell. I really like his work as well, but I'm not quite yet so narcissistic to think you're actually talking about me. Maybe someday... :)

Jacob Egner writes:

Thomas Sewell: You are correct...and I have a vague memory of a long time ago realizing "hey, this guy is tantalizingly one letter off from Thomas Sowell"...but my fallibility caught up to me. I think part of it is you reliably make high-quality, informative comments which makes it easy to think you are the highly accomplished and lovable Thomas Sowell.

Scott Sumner: If I'm a curmudgeonly old man (mid 30s) with a penchant for saving, how do I talk myself into preferring 2% annual inflation over a milder seeming 1% or 0.5%? (Assuming that 2% annual inflation is actually better for society than 1% or 0.5%.)

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