A few months ago the Federal Reserve seemed to be inexorably moving toward adopting an inflation targeting policy regime. Fed Chairman Ben Bernanke is known to support such a framework having co-authored several articles and books on the subject. Moreover, his institutional hand had been strengthened by Frederic Mishkin’s appointment as Vice-Chairman of the Fed, Mishkin being one of Bernanke’s co-authors.
This situation has been transformed by Congressman Barney Frank’s assumption of the Chairmanship of the House Financial Services Committee. That is because Frank is known to be an inflation targeting skeptic, and his Chairmanship sets the stage for an important policy debate that also pertains to policy in Europe, Canada, and developing economies.
The economics profession is widely identified with supporting inflation targeting. However, the profession is also unusually monolithic, which makes it important that alternative positions get heard.
Former Federal Reserve Chairman Alan Greenspan long opposed inflation targeting on “process†grounds. Though known as an opponent of inflation, Greenspan’s view was that an explicit inflation target would be a millstone around the Fed’s neck. In particular, it would limit flexibility and discretion to adjust policy in response to unexpected circumstance. Additionally, inflation targeting could promote damaging mechanical policymaking, as happened with money supply targeting in the late 1970s. Lastly, it could provide an anvil on which financial markets could hammer and corner policy.
Greenspan’s opposition reflects his policymaker acumen. But there is a deeper case against inflation targeting that rests on economic theory and differences in the way the economy is understood.
Today’s economic consensus is rooted in Milton Friedman’s notion of a natural rate of unemployment that harkens back to classical economics, which ruled thinking in the Great Depression era. According to this classical view inflation and monetary policy have no lasting impacts on the unemployment rate or real wages, which are determined by labor supply and demand conditions that are independent of inflation. Moreover, inflation cannot affect economic growth, which is determined by labor force growth and the rate of technological advance that are again independent of inflation.
These propositions represent today’s consensus. But there is another view that holds there is a trade-off between inflation and unemployment. Slightly higher inflation can reduce unemployment because it greases the wheels of adjustment in labor markets. It is hard to lower wages because of trust and conflict issues. Consequently, instead of lowering wages in depressed sectors it is more efficient to raise wages and prices in the rest of the economy, thereby accomplishing the relative price adjustments needed to restore full employment.
Lower unemployment can in turn raise real wages because it gives workers more job options and increases their bargaining power. Finally, higher wages may raise growth by strengthening consumer demand conditions and stimulating investment – but this requires the economy to be “wage-ledâ€. Alternatively, if the economy is “profit-ledâ€, higher wages may lower growth by diminishing profitability and discouraging investment.
The important point is there are two competing coherent views of the economy, and they generate very different policy perspectives. According to the current consensus, monetary policy only affects inflation, which encourages very low inflation as the Fed’s goal. However, the minority post Keynesian view sees monetary policy as having lasting impacts on inflation, unemployment, real wages, and maybe growth. That makes inflation one concern among many.
This difference means that inflation targeting is an undesirable frame for public policy. Inflation is a “bad†in the sense that we would all prefer high employment without inflation. Consequently, if monetary policy is presented purely in terms of an inflation target, there will be a tendency to choose a low target. If the choice is presented as two versus three percent inflation, two percent is likely to win out and policy will also tend to privilege addressing inflation risks over employment risks.
However, if the reality is monetary policy impacts a quadruple consisting of inflation, unemployment, real wages, and growth, two percent inflation may be inferior to three percent inflation accompanied by higher real wages, lower unemployment, and possibly faster growth. That is the economic logic behind skepticism about inflation targeting as a policy framework.
Copyright Thomas I. Palley
Thomas,
Your commentary was posted on the Economists’ View website of Mark Thoma, and I posted my comments on it as pasted below.
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Mark, thank you for the post. It’s often helpful for the author to define what he believes the consensus to be on an issue, as Thomas Palley has done. But I find his description of consensus to be off the mark by quite some distance regarding current monetary theory.
He says today’s consensus is that monetary policy and inflation have no impact on employment or economic growth. He says this consensus is rooted in Friedman’s theory of a natural rate of unemployment which is traceable to classical theory during the Depression. I believe both statements are erroneous in all material respects.
The classical model certainly does not comport with a consensus that monetary policy has no impact on employment or economic growth, and I can’t identify anyone who would agree with that analysis. Financial markets worry every moment of every day about the Fed’s policies and practices, knowing they will affect employment and growth, and the markets are right in that regard.
In reality, as I commented on an earlier thread, the funds rate target that the Fed uses as its only declared instrument of monetary policy is specifically designed to affect employment. The Keynesian theory that advises its use foresees that raising the overnight interest rate will reduce aggregate demand by raising cost of credit to consumers. Lower aggregate demand will beget lower production, which in turn will lower employment. The lower employment will increase the number looking for work, thereby lowering the economic leverage of those workers trying to achieve wage increases. This is the desired outcome, as it is viewed as releaving wage pressures on prices of products and services.
That has been and is presently the theoretical model used by the Fed, and is the practical effect of the funds rate target. This is attested by written assessments of scholars and practitioners most familiar with Fed operations. The theory is entirely Keynesian or post-Keynesian, as classical theory views control of domestic interest as unsound and incapable of producing stable currency.
As to whether inflation affects economic growth, classical analysis indicates that it most certainly does, and that the effects are negative. In summary, inflation is a deterioration of the quality of the currency because the change in value requires repricing of all goods, services and assets priced in the currency. In the absence of accurate repricing, value or marketability will be lost. With trillions of items to be repriced with each change of currency value, this is very burdensome. When the changes are secret or hard to measure, or unpredictable, uncertainties arise that greatly increase the risk and impede the process of capital investment.
The thrust of Palley’s comments is that he wishes to avoid the pain of Keynesian funds rate hikes, meaning the higher unemployment they would bring, and to do so he is willing to argue that higher inflation may actually be a good thing. He is right to object to higher funds rates and higher unemployment. He is wrong to think higher inflation will be good for economic growth or employment; that would bring stagflation again.
The best outcome for employment, economic growth and inflation is provided by Fed policy targeting stable value for the dollar. That eliminates inflation entirely, and allows labor to compete for higher wages whenever labor or skills are in short supply in a growing economy, without the Fed dampening the opportunity on every occasion. In a non-inflationary economy, wages give important signals to producers and workers, just like prices do.
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Thomas, if I have misunderstood you in any respect, or if you wish to discuss my views, please let me know.
Wayne
Even those who are willing to accept 2% inflation must accept that inflation has some benefits — or that forcing it down to zero would have costs, which is the same thing. So among those who are willing to accept, and see some value in, some inflation, the question is HOW much, and how should it be controlled? Will it tend to get out of control if we accept that 3% might be beneficial? If we believe so, we’ll perhaps TALK about zero inflation (i.e., no benefit to inflation), while in fact accepting a more workable, less costly, 2%. So if we want higher inflation — perhaps just 3% — the question is, how can we then keep it from getting out of control? How can we determine the “optimal” inflation rate, and keep it there? (So it seems we’re still talking about inflation-targeting — aren’t we?)