Friday, December 12, 2014

Inflation Targeting's Big Wrinkle

Inflation-targeting central banks are in an awkward position. Their objective is to stabilize the rate of inflation, but they now face a development that could jeopardize it: the surge in oil production that is driving down oil prices. The decline in oil prices is a much-needed boon to the global economy, but it may also mean inflation temporarily drops beneath its targeted value.  What to do? David Wessel calls this development a wrinkle for central bankers:
On balance, falling oil prices are welcomed by the world’s major central banks, but there is a wrinkle. Lower oil prices are good for growth in the U.S., Europe, and Japan. But they’ll also reduce the headline inflation rate at a time when the central banks, particularly the Bank of Japan and the European Central Bank, are struggling toraise the underlying inflation rates in their economies and keep public and investor expectations of inflation from falling. That involves a lot of psychology as well as economics. While central bankers often look beyond volatile food and energy prices to gauge the underlying inflation rate, they know that ordinary consumers don’t. “It’s important that [the drop in oil prices] … doesn’t get embedded in inflation expectations,” the ECB’s Mario Draghi said last week.
This wrinkle has generated a lot discussion on how the Fed should respond. As noted by Cardiff Garcia, both Fed officials and commentators are divided over it. This wrinkle, in short, is adding some uncertainty about the future path of monetary policy.

The interesting thing about this wrinkle is that it is not a new problem. It is just the latest supply shock which always have been problematic for inflation-targeting central banks. Supply shocks push output and inflation in opposite directions and force central banks into these awkward positions. 

Supply shocks were an issue in 2002-2004 when the much-ballyhooed productivity boom (a positive supply shock) of that time made Fed officials worry about deflation. They consequently kept interest rates low even though the housing boom was taking off. Supply shocks were also an issue in the fall of 2008 when Fed officials were concerned about rising commodity prices (a negative supply shock) and, as a result, decided to do nothing at their September FOMC meeting despite the collapsing economy. 

Across the Atltantic, the ECB has struggled even more with supply shocks. The ECB raised interest rates multiple times in 2008 and 2011 in response to the commodity price shocks (negative supply shocks). Below is a figure from a Robert Hetzel paper on this crisis that shows how misguided the rate hikes were. They occurred even though spending was already falling. It is no wonder the Eurozone has struggled so much since 2008.

One can trace this wrinkle back further. Ben Bernanke, Mark Gertler, and Mark Watson argue the reason oil supply shocks have historically been tied to subsequent weak growth is not because of the shocks themselves, but because of how monetary policy responded to those shocks. That is, central banks typically responded to the inflation created by the supply shocks in a destabilizing manner. With the advent of inflation targeting in the early 1990s, this wrinkle has become institutionalized across most central banks.

Now in theory modern inflation targeting should be able to handle these shocks. For the modern practice is to do 'flexible inflation targeting' which aims for price stability over the medium term and therefore allows some wiggle room in responding to supply shocks. The problem, as demonstrated above, is that in practice it rarely works. Responding to supply shocks in real time requires exceptional judgement and usually some luck. In fact, as I note in this policy paper, some scholars think that the successes of inflation targeting prior to the crisis were due largely to luck. There were simply fewer supply shocks during the early years of inflation targeting. Going forward, this seems less likely given the rapid productivity changes of an increasingly digitized world. So this problem is not going away and is likely to get bigger.

What is needed, then,  is an approach to monetary policy that does not get hung up on supply shocks. It would fully offsets demand shocks, ignore supply shocks, while still maintaining a long-run nominal anchor...if only  there were such an approach. Oh wait, there is such an approach and it is called nominal GDP targeting.


  1. Ignore supply shocks? Strikes me that could give you lower real GDP than is possible under some conditions. E.g. assume a supply shock that causes prices to rise at 6%pa. NGDP target is 3%pa growth. Assume all else constant (productivity, population, labor participation rate, etc ). That would give you a 3%pa decline in real GDP (and excess unemployment). In that situation, I think most people would prefer a 6% inflation and constant real GDP.

    1. Why in the world would policy-makers target 3% NGDP growth? With an inflation target of 2-4% (say) and target real GDP growth of 3% (long-term trend), wouldn't the NGDP target be 5-7%? Targeting 3% NGDP growth is the same as targeting zero inflation.

    2. Don,

      “Why in the world would policy-makers target 3% NGDP growth?” Because that’s what NGDP targetters advocate: a rigid and never varying target. There is of course some debate between NGDPers on whether the figure should be 3% rather than 4% or 5% etc. But having chosen some percentage, they believe in sticking to it. And if you’re saying that doesn’t make sense, I quite agree.

  2. Oil, commodities, and rates have fallen. Roc's in money flows = roc's in nominal-gDp (proxy for all transactions in Fisher's transactions concept, the "equation of exchange"). Monetary policy has been contractive, not expansive (QE notwithstanding). Even short-term shocks are inherently mendable.

    05/1/2014 ,,,,, 0.39
    06/1/2014 ,,,,, 0.34
    07/1/2014 ,,,,, 0.34
    08/1/2014 ,,,,, 0.32
    09/1/2014 ,,,,, 0.28
    10/1/2014 ,,,,, 0.26
    11/1/2014 ,,,,, 0.27
    12/1/2014 ,,,,, 0.24
    01/1/2015 ,,,,, 0.24
    02/1/2015 ,,,,, 0.28
    03/1/2015 ,,,,, 0.25

    A 39 percent decline in long-term money flows (proxy for inflation), since May.

    Monetary policy objectives should be formulated in terms of desired rates-of-change in monetary flows M*Vt relative to rates-of-change in real-gDp [ Y ]. Rates-of-change in nominal-gDp [ P*Y ] can serve as a proxy figure for rates-of-change in all transactions [ P*T ]. Rates-of-change in real-gDp have to be used, of course, as a policy standard

  3. The distributed lag effect of money flows is not long and variable. The lags have been
    demonstrably, mathematical constants, for over 100 years (which I can't explain). Thus, targeting gDp is very easy (regardless of supply side shocks). With limited upward and downward price flexibility (e.g., sticky wages), unless money expands at least at the rate prices are being pushed up, output can't be sold, & hence jobs will be lost.

  4. The value of money is represented by various price indices (even though no overall index, or average of all prices, exists, or is representative, nor is any specific commodity always affected). The price level represents the long-run trend (chronic, across-the board increase), in the average change of a group of prices (not volatile, specific, or transitory prices). Thus, no single figure exists which represents the value of money. The price level is an economic time series (sequence of data points).

    Inflation is a monetary phenomenon. Only price increases generated by demand, irrespective of changes in supply, provide evidence of inflation. There must be an increase in aggregate monetary demand which can come about only as a consequence of an increase in the volume and/or transactions velocity of money. The volume of domestic money flows must expand sufficiently to push prices up, irrespective of the volume of financial transactions, the exchange value of the U.S. dollar, and the flow of goods and services into the market economy.

  5. "rising commodity prices (a negative supply shock)"

    How can a change in a price be a supply shock? Are you not "reasoning from a price change" here?


  7. Alexander Salter:

    Funny, a list of all the rules that don't work.

  8. CPI dropped 0.3% MoM in November - biggest drop since Dec 2008. This isn't about just oil. Roc's in long-term money flows (proxy for inflation), have decelerated (the price level).