Inflation targets are bad economics

When the Full Employment Act of 1946 passed into law it created the President's Council of Economic Advisers and the Joint Economic Committee, the two most influential economic policy offices in the federal government. The president was given broad authority to utilize fiscal and monetary policy to promote, in what is possibly the most famous phrase in economic legislation, "maximum employment production and purchasing power."

The Act ratified activist government, and the phrase set down the order of priority: (1) full employment, (2) maximum growth, and (3) stable prices. Five years after the passage of the Act, in the so-called Treasury Accords, the Fed (with complicity inside the Treasury) arrogated unilateral control of monetary policy for itself.

Sixty years later the order of priority has been reversed. Activist government is a memory. Markets are run without rules in a bad parody of a mob-run city. The Fed stands like a balding policemen on the sidewalk making sure nobody steals the apples, while the crooks in pin-striped suits run their toxic paper and mortgage scams on the shopkeeper inside. Always pleasant, the Fed holds the door for them on their exit.

Employment is viewed with suspicion, as a potential threat to prices. Production is assumed to be enabled by the hands-off enabling of cowboy corporations. Inflation is a bogeyman.

As we wrote yesterday, the claim that the falling dollar will not result in rising prices is absurd. Not only are the dollar prices of commodity imports like oil and metals raised by dollar weakening, but the prices of domestic goods that have export markets will be bid up. Sooner or later the Chinese currency will have to bend to rising energy prices and environmental degradation.

Typical among the patronizing Monetarists is the following exerpt from a blog (Economist's View, February 7, 2007):

To help with the discussion, let the rule for monetary policy be of the standard modified Taylor rule form: ff_t = a + bff_t-1 + c(y_t-y_t*) + d(π_t - π_t*) + u_twhere ff is the federal funds rate target, y is output, π is inflation, and u is the uncontrollable part of policy. A * indicates the target value of a variable and a, b, c, and d are choice parameters for the Fed. The parameters c and d determine how forcefully the Fed responds to deviations from its output and inflation targets.

(In more general models the deviations might be expected future deviations rather than the deviations today, there are issues about whether to use real-time or revised data, the rule can have additional terms, and there are other issues as well such as what target to adopt when market imperfections are present, but this will suffice.) Barney Frank says we must pay "equal attention to unemployment.” If he means that the Fed should respond as forcefully to deviations of output from target as it does deviations of inflation from target, that is at odds with current monetary theory which states that the best way to stabilize output and employment - Barney Franks' concern - is to respond more forcefully to inflation deviations than to output deviations. Thus, the value of d is around three times as large as c in standard formulations. If he means the Fed should take account of deviations of output from target (or employment deviations), they already do that. As to explicit inflation targeting, the issue is whether to announce the value of π_t*, the inflation target.

Barney Frank is worried this will elevate the importance of inflation deviations, but nothing I know of suggests that announcing π_t*changes the values of d or c. Targeting inflation is a means to an end - that of output and employment stability just as Barney Frank wants - and not an end in and of itself. Both theory and evidence tell us that the Fed can stabilize employment and output around their long-run trends, but it cannot change the long-run trends themselves with monetary policy.

Thus, the best the Fed can do is to stabilize the economy around these long-run trends and that, we believe, requires stable and low inflation and an aggressive response to deviations of inflation from target.

Here we have precision rather than accuracy. Two problems:

• Economics has no independent variables, so to try to force inflation to operate in dependence to other variables is simply bad math and bad economics.


• Economics is not a closed system. Leakage is the rule.

The importing of thermodynamic thinking into economics around the turn of the last century was a conceptual error then and has continued to this day as a primary fallacy of the latest Neoclassical economics.

To say that anything is "at odds with current monetary theory" is similar to saying, "We waved at the moon and it went from this side of the sky to the other, so why are you not listening to us?" You will remember the Reagan-Volcker recession of the early 1980s, when "current monetary theory" suggested a simple, painless way of reducing inflation was to reduce the quantity of money, because inflation was simply too much money chasing too few goods. Reducing the quantity of money would bring prices into the comfort zone without pain.

Result, lots of pain. Prices came down after Volcker blinked and oil prices backed off, but not until after millions of unemployed, unwitting inflation fighters, had their lives sometimes permanently damaged.

The idea that price stability in the context of these discussions is intimately associated with anything other than low volatility in prices is not borne out by any evidence, in spite of the neat phrase. The absence of volatility is no indication of stability. Witness the recent financial market collapse after years of non-volatility. In fact, in the case of prices, keeping the lid on will only create pressure that will hurt people and businesses. The falling dollar must be reflected in prices, and translated in an orderly way. Order is stability. Suppression is only building pressure.

We have had hundreds of billions of dollars in trade deficits for decades. Standard economic theory has no explanation for this. The currency is supposed to adjust to keep the trade in real goods and services relatively balanced. The currency is now adjusting. To make the adjustment orderly, we do not ignore it or pretend it is bad. Instead, we should create the conditions for a strong economy which can support its currency by something other than reputation.

All of this would not be so important except for the fact that the Fed has only one tool, or perceives that it has only one tool -- the interest rate. The interest rate is used to hammer down inflation, provide bail-out liquidity for financial sector mistakes, and open demand in the broad economy to counteract downturn.

• As a tool against inflation, it is bad when it is applied to cost-push inflation, because it does not reduce costs, but increases them.


• As bail-out to the financial sector it is bad because the financial sector is not in a liquidity crisis, it is in an information crisis. It is not that there is no liquidity to buy the toxic product, it is that nobody knows what they are worth. (Though it is likely the information is being kept in the closet because the purveyors don't want people to know how badly they've been duped.)


• As a way of opening demand to counteract a downturn, interest rates work after a lag. But of course, the direction is the opposite from that utilized in the inflation fight.
  

One possible silver lining to the financial sector fiasco is that it will prevent the Fed from doing what it wants to do when falling dollar inflation hits their spreadsheets. Of course, the best thing it could do would be to back away from the button and get to work putting some reins on the renegade market.