The perils of inflation targeting

Inflation targeting is popular amongst central banks, but not everyone is a fan. Axel Leijonhufvud writes about The perils of inflation targeting over at the VoxEU website. He fears it fuels cheap money and asset bubbles.

An expansionary monetary policy and an historical conjuncture that happens to produce no inflation will lead to asset price inflation and deterioration of credit. At some stage, central banks will have to mop the liquidity or see inflation do it for them.

Of course the Fed does not (yet) have an explicit inflation target, but it has managed to help produce two notable asset bubbles in the past decade all the same.

Comments

[Arthur Eckart]

When the Fed targets prices, output fluctuates little. When the Fed targets output, prices fluctuate a lot, which leads to instability. I suspect, if the Fed targeted the money supply, that would also lead to instability, because of shifts in the foreign exchange market or changes in the velocity of money in the short-run. However, the money supply determines prices in the long-run. Asset prices are residuals of monetary policy. So, price stability (of goods & services) is the Fed's best choice, although it also attempts to keep inflation expectations low, i.e. a cautious stance. U.S. monetary policy can't get much better.

[Arthur Eckart]

Also, I may add, it's not important whether the Fed Funds Rate is 10% or 5%, the money supply is high or low, or how many booms and busts take place in asset markets. What's important is maintaining sustainable growth, which is optimal growth.

However, many shocks take place, e.g. Y2K (when the money supply spiked higher and then lower around 2000), 9-11, an oil shock (or commodities in general, e.g. gold, copper, and steel), minor technology shocks in the '80s and '90s, and the quick and massive "Creative-Destruction" process in the early '00s, where resources were freed-up in Information Age
firms, along with Agricultural and Industrial Revolution firms, and shifted into emerging industries, resulting in more or better output per
input in older industries.

In the '90s, U.S. actual output was slightly above U.S. potential output, and in the '00s, U.S. actual output was slightly below U.S. potential output. The U.S. remains in position to gain the most, or lose the least, in the global economy. However, the gains over the next few years will likely be mostly in production rather than consumption. So, wage and employment growth may rise faster than profit growth, or exports may rise faster than imports.

[Arthur Eckart]

Large economies tend to expand. Contractions are rare. Many only focus on purchasing power, e.g. $1 in the past is worth $0.10 today. However, given living standards have risen substantially, over time, it shouldn't be ignored that the increase in output must have been greater than the rise in prices.

[G]

I'm an engineer by trade, not an economist, so please forgive me if my questions are not so well informed.

Can anyone explain why the Fed targets price inflation? It would seem more logical to target a very low level of monetary inflation. Arthur, why would targeting monetary inflation cause instability, exactly? Can the money supply can be significantly effected by the monetary policies of other countries, leading to possible instabilities unless the Fed acts in response?

If foreign exchange markets are a major cause, what about a currency which has global usage and acceptance? I suppose the dollar never got that widely accepted. I wonder how something like the Terra, or even something as simple as a pure gold standard would do? I suppose foreign governments could then alter the money supply by trading gold or the commodities the Terra is based off of? I can't help but think that manipulation in foreign markets due to foreign policies wouldn't be harmful to all parties involved.

I'm having a hard time understanding why changes in the short-term velocity of money would be a problem. I would think that with more stable monetary growth, we'd have a more stable velocity of money.

I would expect there is a lot of political pressure on the Fed to inflate the money supply more than would be necissary, because of the advantages to debtors. And what politician wants to cut back on inflation and possibly be blamed for a temporary recession?

[Arthur Eckart]

The U.S. central bank printed excess money to maintain sustainable growth, because the excess money was absorbed by many U.S. major trading partners. If these trading partners fall into recessions, the world would be flooded with U.S. dollars (causing a precipitous fall in the Dollar). This is why the Fed is "sitting on the fence" with a Fed Funds Rate at 5 1/4% (after the tightening cycle), although U.S. economic growth has slowed. Changes in fiscal policy can change the velocity of money, MV = PT. However, in the long run, V and T are constant. So, M equals P.

[Arthur Eckart]

Also, I may add, in the equation MV = PT, if M and P are constant, then V = T, i.e. V, the velocity of money, or the number of times money is exchanged, equals T, the number of transactions, or the quantity of goods exchanged. T can be represented by real GDP. The goal of monetary policy should be to keep actual GDP close to potential GDP, which smooths-out the business cycle creating optimal growth (since there's neither strain nor slack in the economy). The fact that there are monetary tightening and easing cycles, to close output gaps, are attempts to smooth-out T in the short-run. V and T fluctuate in the short-run, which require adjustments in M to stabilize P and smooth-out T. For example, if people decide to hoard money, then V and T will fall (in the short-run). So, M needs to rise (higher than a constant growth rate).

[Arthur Eckart]

Moreover, political pressure has little real influence on the Fed, given it's independent structure. The Greenspan and Bernanke Fed would prefer a mild recession than accelerating inflation. Of course, the Fed works in the future economy, because of lags in the adjustment process, which is difficult. I'm sure the Fed would prefer a domestic currency than a global currency, because of better U.S. monetary policy. The ultimate goal of the Fed is to raise U.S. living standards at the fastest sustainable rate, including at the expense of foreign countries. U.S. globalization and fiscal policies are also designed to capture the most gains.

[G]

Thank you for the great information. I've not been able to find anything like this elsewhere.

I am slightly skeptical on your assertion on political pressure and the Fed, because I know the Supreme Court was designed with similar political isolation in mind. That seemed to fail in the face of FDR's New Deal, among other things. But I understand the current system is probably very preferable to congressional management of the money supply, which would be downright frightening.

I cannot help but be more skeptical of the Fed being able to predict what real GDP is. As far as I've read, the market process itself is the best means for determining the price level of anything. It seems to me that if money is horded, it must be in response to an anticipated greater demand for the dollar at a later date, which in itself would work to predict and preempt a contraction of the money supply which would increase the demand for the dollar. Alternatively, if saved money is spent and V and T rise, wouldn't that be in response to an anticipated decrease in demand for the dollar in the future? I would think that fluctuations in the growth of the money supply caused by the Fed would prevent people from making rational decisions on future currency investments. If someone correctly anticipated a period of deflation and invested in the dollar, the Fed would counteract this by increasing the money supply and causing malinvestment for the rational actors in the market. Is there something I am missing, or is this a valid criticism?

I started looking into monetary policy after I wondered how something like the housing bubble came into being. It seemed illogical to me that investors across the nation would suddenly partake in such extreme malinvestment, seemingly independent of each other. After understanding how our monetary system worked, I felt it was logical that an increase in the money supply would create cheaper credit, which could inflate markets (like real estate) closely tied with credit. All in all I'm wondering if enforced monopoly control of a national currency is really a good thing.

Thank you for any help.
-Grant

[Arthur Eckart]

Grant, thanks. In reply to your first paragraph, the Fed is aware of politics. However, at least over the Greenspan and Bernanke Fed, politics hasn't influenced monetary policy. In early '92, Bush the first wanted the Fed to ease the money supply faster. However, Greenspan (also a Republican) didn't. The following quarter after Bush lost the election, GDP growth was reported much higher. So, the Fed may have cost Bush the election. Also, after hurricane Katrina, Bush Jr wanted the Fed to pause tightening the money supply. However, Greenspan continued to tighten at each meeting, which turned out to be correct monetary policy. Moreover, it appeared Greenspan was helping Clinton, although it was really sound monetary policy. In the mid or late '90s, Greenspan eased the money supply to a point where many thought inflation would accelerate. However, it didn't. Furthermore, many thought Bernanke, who believes the U.S. can always avoid a liquidity trap by throwing money out of a helicopter (hence the nickname helicopter Ben) was an inflation dove. However, so far it seems Bernanke is an inflation hawk (or prefers a mild recession than accelerating inflation).

[Arthur Eckart]

Grant, I agree, GDP is difficult to predict, in the short-run, e.g. because of seasonal and cyclical factors, along with structural breaks. However, the Fed doesn't target GDP (although, in the '90s, the Fed believed potential GDP was understated). It targets the general price level (e.g. GDP Price Deflator and Personal Consumption Expenditures). Also, if the Fed targeted individual markets, that may lead to economic instability, perhaps much worse than targeting money or GDP. If people expect prices to fall (rise), they'll save (spend). So, price stability is important to smooth-out real GDP.

[Arthur Eckart]

Also, I may add, given the Fed's crude tools, it cannot micromanage the economy, because targeting one market will influence other markets. However, the Fed may want fast technology growth, e.g. to raise productivity, or housing to expand quickly, e.g. to lower wage growth (since homeownership tends to make people more responsible, e.g. to remain employed longer). However, the Fed may not want commodity prices (e.g. oil, copper, and steel) to rise quickly, because of higher input costs. So, the Fed may prefer a tech or housing bubble rather than a commodities bubble.

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[Florida Certified Public Accountants]

A financial crisis is what you get when profits and a sustainable growth are the main points any countries' economy.
They didn't realize that all those mechanicims were to control private actions.

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