NGDP targeting has been gaining popularity recently. But targeting market-based inflation forecasts will be about as good under most conditions [1], and we have good markets that forecast the U.S. inflation rate [2].
Those forecasts have a track record that starts in 2003. The track record seems quite consistent with my impressions about when the Fed should have adopted a more inflationary policy (to promote growth and to get inflation expectations up to 2% [3]) and when it should have adopted a less inflationary policy (to avoid fueling the housing bubble). It’s probably a bit controversial to say that the Fed should have had a less inflationary policy from February through July or August of 2008. But my impression (from reading the stock market) is that NGDP futures would have said roughly the same thing. The inflation forecasts sent a clear signal starting in very early September 2008 that Fed policy was too tight, and that’s about when other forms of hindsight switch from muddled to saying clearly that Fed policy was dangerously tight.
Why do I mention this now? The inflation forecast dropped below 1 percent two weeks ago for the first time since May 2008. So the Fed’s stated policies conflict with what a more reputable source of information says the Fed will accomplish. This looks like what we’d see if the Fed was in the process of causing a mild recession to prevent an imaginary increase in inflation.
What does the Fed think it’s doing?
- It might be relying on interest rates to estimate what it’s policies will produce. Interest rates this low after 6.5 years of economic expansion resemble historical examples of loose monetary policy more than they resemble the stereotype of tight monetary policy [4].
- The Fed could be following a version of the Taylor Rule. Given standard guesses about the output gap and equilibrium real interest rate [5], the Taylor Rule says interest rates ought to be rising now. The Taylor Rule has usually been at least as good as actual Fed policy at targeting inflation indirectly through targeting interest rates. But that doesn’t explain why the Fed targets interest rates when that conflicts with targeting market forecasts of inflation.
- The Fed could be influenced by status quo bias: interest rates and unemployment are familiar types of evidence to use, whereas unbiased inflation forecasts are slightly novel.
- Could the Fed be reacting to money supply growth? Not in any obvious way: the monetary base stopped growing about two years ago, M1 and MZM growth are slowing slightly, and M2 accelerated recently (but only after much of the Fed’s tightening).
Scott Sumner’s rants against reasoning from interest rates explain why the Fed ought to be embarrassed to use interest rates to figure out whether Fed policy is loose or tight.
Yet some institutional incentives encourage the Fed to target interest rates rather than predicted inflation. It feels like an appropriate use of high-status labor to set interest rates once every few weeks based on new discussion of expert wisdom. Switching to more or less mechanical responses to routine bond price changes would undercut much of the reason for believing that the Fed’s leaders are doing high-status work.
The news media storytellers would have trouble finding entertaining ways of reporting adjustments that consisted of small hourly responses to bond market changes. Whereas decisions made a few times per year are uncommon enough to be genuinely newsworthy. And meetings where hawks struggle against doves fit our instinctive stereotype for important news better than following a rule does. So I see little hope that storytellers will want to abandon their focus on interest rates. Do the Fed governors follow the storytellers closely enough that the storytellers’ attention strongly affects the Fed’s attention? Would we be better off if we could ban the Fed from seeing any source of daily stories?
Do any other interest groups prefer stable interest rates over stable inflation rates? I expect a wide range of preferences among Wall Street firms, but I’m unaware which preferences are dominant there.
Consumers presumably prefer that their banks, credit cards, etc have predictable interest rates. But I’m skeptical that the Fed feels much pressure to satisfy those preferences.
We need to fight those pressures by laughing at people who claim that the Fed is easing when markets predict below-target inflation (as in the fall of 2008) or that the Fed is tightening when markets predict above-target inflation (e.g. much of 2004).
P.S. – The risk-reward ratio for the stock market today is much worse than normal. I’m not as bearish as I was in October 2008, but I’ve positioned myself much more cautiously than normal.
Notes:
[1] – They appear to produce nearly identical advice under most conditions that the U.S. has experienced recently.
I expect inflation targeting to be modestly safer than NGDP targeting. I may get around to explaining my reasons for that in a separate post.
[2] – The link above gives daily forecasts of the 5 year CPI inflation rate. See here for some longer time periods.
The markets used to calculate these forecasts have enough liquidity that it would be hard for critics to claim that they could be manipulated by entities less powerful than the Fed. I expect some critics to claim that anyway.
[3] – I’m accepting the standard assumption that 2% inflation is desirable, in order to keep this post simple. Figuring out the optimal inflation rate is too hard for me to tackle any time soon. A predictable inflation rate is clearly desirable, which creates some benefits to following a standard that many experts agree on.
[4] – providing that you don’t pay much attention to Japan since 1990.
[5] – guesses which are error-prone and, if a more direct way of targeting inflation is feasible, unnecessary. The conflict between the markets’ inflation forecast and the Taylor Rule’s implication that near-zero interest rates would cause inflation to rise suggests that we should doubt those guesses. I’m pretty sure that equilibrium interest rates are lower than the standard assumptions. I don’t know what to believe about the output gap.