Yesterday the inflation data for the EU countries was released. For the euro zone inflation remains high at 2.7% while the ECB target is at “utmost 2%”. If these were normal times (i.e. before 2007) the headlines in the mainstream media would have demanded ECB to take immediate action.
Instead, we are actually witnessing a witch hunt of the Inflation Targeting (IT) regime. There are even some economists who are blaming the current economic crisis on the IT regime which was so successful that it created bubbles all over the rest of the economy (but the area which was measured by the consumer prices). In my view this is utter non-sense. The IT regime came about to solve the big inflation problem of the 70s and 80s and to introduce a transparent and independent monetary policy. It is harder (but not impossible) to cheat in a rules based policy environment.
But in our curent environment the ECB will get away with higher inflation as most economists are in fact busy trying to convince the public that monetary policy should be used to spur economic growth. In fact, all the ECB has to do these days is to forecast lower inflation and call the current above target inflation a temporary phenomenon. The trick is not new and it was used by the ECB (and other central banks) in 2011 when at the beginning of the year it was forecasting inflation for that year at 1.9% and for the end of 2012 at 1.8%. Guess what is the ECB forecasting for the end of this year and for the end of 2013? 1.9% and 1.7%. As long as the forecasts are below target the ECB does not have to act.
However, even with current inflation rate running above target there are voices saying that monetary policy in the euro area and in the US is running too tight. The measure used to show this is the Nominal GDP (NGDP) level versus a long run trend. And to solve the problem, i.e. NGDP below trend, they propose a new target for the monetary policy:NGDP level. To be honest the idea is not new or that outrageous as even Milton Friedman has mentioned something similar in his book Money Mischief: Episodes in Monetary History.
The idea in a nutshell is too relax monetary policy until NGDP gets back to its trend. I am not going to discuss the actual details of how monetary policy will be implemented in such an environment, for example you would need a pretty reliable forecast of the NGDP for it to work, as there are much better economists out there that can help you out with this (Scott Sumner, Lars Christiansen, Marcus Nunes, Nick Rowe, to name a few). What I want to talk about is the case when the NGDP is above target.
These days a NGDP target makes sense, in theory at least, as by some measures current NGDP in the US and the euro area is below some trend. Therefore, a loose monetary policy would help NGDP move to its long run trend.
But there is a problem: NGDP trend might not be constant. Let’s look at the graphs below. I use an H-P filter (purely statistical method) to separate the trend from the cylcle in the NGDP for the euro area and the US. If we use the entire sample we end up with an NGDP that is right on its long term trend at the end of 2011. This, no need for further monetary stimulus.
What’s all the fuss then about NGDP being below trend? Well, if we shorten the sample and apply the HP filter for a data only up to the first quarter of recession we end up with a much higher NGDP long run trend. So, if we compare the current NGDP level with that trend then yes we are below and we need to catch up.
But who says that that is the long run trend for the NGDP? By now we all know that the 2006-2007 period was seen as the “Irrational Exuberance” period. Thus, if we shorten the sample further and apply the HP filter one more time we end up with a long term trend that is closer to the one which uses the data set up to the end of 2011. Thus, we could assume that the period of 2006-2008 was a period of overheating fueled by a too loose monetary policy and thus more of an anomaly than a normal period.
There is one more thing that I find odd about the NGDP targeting . IF we look at the period up to 2008 we see that the NGDP level was barely above its long run trend at the end of 2008. By this measure the economy was not overheating at that time and thus it would have not required a tight monetary policy. But we all know that the economies of both US and euro area were overheating by 2007, as consumer prices correctly signaled.
Let’s forget all this about shifting trends and assume that there is one trend and the NGDP level is above it (i.e. the economy is overheating). Then, monetary policy needs to actually drive the economy in recession to bring the NGDP level below target,not at target but below, because it is the only way to bring NGDP at target in the future. After all we have witnessed policy makers do since 2007 do we think for one moment that they will allow monetary policy to push the economy in recession when things are “good”? What if NGDP level is above target right in the middle of an election year. What are the odds that central banks will tighten monetary policy in those conditions? I venture to say: slim to none.
While I think NGDP level is the wrong target for monetary policy there is one characteristic of this regime that makes sense to be adopted by the one targeting prices: the level. If there is something that would improve IT is to shift from inflation to price level targeting (PT) (see Svensson 1996 for more details). The main reason is that under the IT regime bygones are bygones and in the PT this is not true.
What does this mean? Well in the current IT regime all the ECB has to do is to forecast inflation below target in the future. It does not have to deliver, as we see today, as long as it keeps forecasting lower inflation, i.e. bygones are bygones. But in the PT regime this is not possible. If the price level is above its target then monetary policy has to actually deliver lower price level and not just a forecast of that, in order for price to be on target in the future. Of course, the problem of trend shifts (due to exogenous reasons) remains and it will create some interesting challenge for the policy makers.