I was thinking of skipping commenting on the Brookings Institution’s “Rethinking the 2 per cent inflation target”, but given the plethora of similar events on stabilization policy being held and the quality of some of the commentaries – in particular John B. Taylor’s – I thought we could try to chart it out for you1.
In essence, the current debate on stabilization policy seems to be based on the premises that due to lower potential growth (and, hence, lower natural real interest rate) the effective lower bound (ELB/ZLB) will more frequently become a constraint on monetary policy. Thus, we either continue with the current supposedly non-optimal regime, an inflation target of two per cent (IT), or move to … “something else”. Thus far, this “something else” is quite narrowly defined and mostly in the realms of monetary policy. The options under consideration are: A higher inflation target of, say, 4% (IT4); nominal GDP level targeting (NGDPLT); price level targeting (PLT), or; a regime shifting between IT and PLT depending on the proximity to the effective lower bound.
1This post relies heavily on the ideas and input from Alexander Pelle and Wadsworth Sykes, my smart(er) colleagues at Macrobond.
Charting out the monetary policy rules being discussed
Now, which one makes more sense? Is there something that matches the FED de facto policies?
– Well, that is what I really appreciated about Taylor’s views when commenting on the alternatives. Taylor holds a strict adherence to using monetary policy rules (what else?) to compare the different alternatives. As he proposes, their respective economic performance can then be evaluated across a host of models. Of course, this approach is neither revolutionary nor even novel, but it makes quite a few things stand out. (In the graphs below, we “benchmark” all the alternative regimes against a traditional Taylor rule – Labelled: “Constant r* & 2% inflation target”.) Due to time constraints, our evaluation of economic performance is largely qualitative.
Chart 1: And then some…
First of all, please note that the standard Taylor rule as well as a timely and correct identification of a lower r* would suggest a lower policy rate in the period leading up to the crisis. A more strict adherence to a Taylor rule could, consequently, have created a much appreciated “inflation buffer” in the depths of the crisis.
As the crisis unfolded, it should be easy to see that the FED not only incorporated a view of a lower natural – neutral – FFR (and potential growth) but, especially taking the various unconventional monetary policy measures into account (the “Wu-Xia FFR Shadow rate”), conducted a considerably more expansionary monetary policy than what a standard policy rule would suggest. This does not necessarily mean that the FED has been wrong in doing so, since (wage) inflation has disappointed, but it rather underlines that the FED has gone out of its way to push inflation towards its target.
The Price Level Targeters
Even so, many clever economists, such as John Williams of SF Fed2, want to see a price level target replacing the current IT-regime as it forces the FED to take into account earlier policy misses, which would not only make up for more frequent run-ins with the ELB but also detract some of the critique from those focusing on long-term income developments and with balance sheet considerations.
However, when putting a PLT into a Taylor-rule framework, some of the difficulties with the PLT-regime become obvious.
Chart 2: The longer you wait…
A PLT-regime would indeed yield a lower-for-longer type of behavior, but the problem with PLT is that it takes time for the deviations to build up and “stress” the policy makers into action. In practice, thus, I have a hard time seeing how this would materially change the behavior of monetary policy. This proposition is underlined by the fact that monetary policy has de facto been more expansionary than what a PLT-type of monetary policy rule would suggest. As for the chance of avoiding the ELB, timely stabilization policy responses should be of essence, something which is not apparent. This is well illustrated by Williams himself who currently argues for steady as she goes policies on the FOMC, resting on arguments of temporary deviations. (OK, I admit, that was kind of a cheap shot.) Do note, also, that we have not taken into account the possibility of a declining r* in this chart. Since such changes are hard to identify in real-time, we defer such modifications to discussions below.
The buffer arguments
Another, perhaps less provocative suggestion, championed by Olivier Blanchard and other luminaries, is simply to hike the inflation target to, e.g., 4% instead of 2%. Long-term, this would create a buffer to the ELB making sure the real policy rate can always (?) become sufficiently expansionary.
Chart 3: Would it make much of a difference?
Again, we have deferred the complication of a possibly lower r* to later discussions. Here, what immediately stands out is the relatively hawkish path from 2010 onwards resulting from a 4% inflation target, mirroring that of a standard Taylor rule. Thus, one cannot help but thinking that simply hiking the inflation target to 4% would have produced the same, and in hindsight erroneous, monetary policy contraction as the standard Taylor rule.
That said, it is also important to note the considerably lower interest rate between 2005 and 2008, which would probably have produced a higher rate of inflation going into the crisis showcasing the stronger buffers to the ELB that proponents of a higher inflation target allude to. For those wanting a more relevant run-through of the effects of a higher inflation target, I recommend you read Blanchard et al and Cechetti & Schoenholtz (w. some nice links).
Mixing it up
Comparing the two main strands of discussion regarding post-GFC stabilization policies; PLT and IT4 regimes, we, at least superficially, also illustrate the mixed policy regimes that Bernanke and others have been suggesting.
Chart 4: Still not sufficiently dovish
Again, we save the discussion on declining r* for later, but it should be all too obvious that even Bernanke’s mixed regime approach (“Constant r* & PLT from 2008”) would have yielded a considerably more hawkish monetary policy than what has been the case when comparing to the monetary policy that the FED has conducted.
However, this graph was mainly meant to illustrate how a 4% inflation target regime and a PLT differs. We can clearly see how following an IT4 monetary policy rule would have been much more aggressive both before the crisis and in its acute phases. A PLT-regime would, on the other hand, produce a policy of a lower-for-longer nature.
Siding with Taylor
In the end, it is hard to unambiguously state that any of the suggested monetary policy rules would have yielded a considerably better economic performance than what actual FED policy has managed. (Yes, especially without evaluating performances in a macro model.) In particular, it seems a lower starting interest rate and stronger initial response to the crisis are probably the two main desired traits of a “better” monetary policy rule. As for lower starting rate, it seems as if even the original Taylor rule would have provided such a policy even though a 4% inflation target, of course, would probably have performed even better in that sense. As for a desired stronger initial response to the crisis (and a lower-for-longer approach), it is by and large a result of the economic deterioration around the time of the crisis (catering to PLT-proponents). Indeed, this is visible in the declining r*, but such developments are very hard to capture in real time and (point) estimates remain highly uncertain as Taylor & Wieland showed a couple of years ago.
As promised, and when also adding a declining r* to our host of monetary policy rules, we get the following results.
Chart 5: Well, it sure is flexible…
Unsurprisingly, when adding a declining r*, all our rules take a step down and flattens somewhat, underlining how important it is for policy makers to swiftly identify structural shifts in r*, decline in GDP-growth. And, again, this is no easy feat. The graph also gives a rough illustration of how a (Nominal GDP Level Targeting) NGDPLT-regime would play out (the grey line: “Declining r* & PLT from 2008”) and despite pointing to considerably lower interest rate over the past 2-3 years, it is largely in line with actual FED policy – especially when incorporating the effects of UMP; the “Wu-Xia FFR Shadow rate”.
To conclude, the standard Taylor rule and the current IT framework has worked well for many decades. Given monetary policy developments in the years preceding the crisis, it is even possible that deviations from this framework amplified the crisis. Furthermore, as developments post-GFC have showed, this framework is indeed flexible, and it is not obvious that the suggested alterations of the monetary policy framework would improve economic performance much.
In my book, the main problem instead seems to be the timely identification of structural shifts in the economy, which could in turn necessitate temporary or permanent modifications of the monetary policy rules. However, are we really sure we can positively and accurately identify such changes? – If not, extreme caution is warranted.
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