John Taylor recently criticized central bank policies in the major economies, and re-iterated his support for a clear rule for the policy instrument. John Cochrane responded:
John Taylor has a lovely little blog post, encapsulating so much in a few sentences. An excerpt with comments (emphasis mine)
…there is a crucial issue which explains much of the enormous difference of opinion between critics and supporters of the Fed’s current policy. Critics such as me and Allan Meltzer … argue that monetary policy should focus on a clear strategy for the instruments of policy. A goal for inflation or other measures of macro performance is not enough if it is simply part of a whatever-it-takes approach to the instruments. Such an approach results in highly discretionary and unpredictable changes in policy instruments with unintended adverse consequences, as we have been seeing in recent years.
Supporters such as Adam Posen… are just fine with the Fed using, even year after year, a whatever-it-takes approach to the instruments of policy as long as there is an overall goal. With such a goal in mind, so their argument goes, the central bank can and should always intervene in any market, by any amount, over any time frame, with any instrument or program (old or new), and with little concern for unintended consequences in the long run or collateral damage in the short run (say on certain groups of people or markets) as long as it furthers that goal.
Critics are very concerned about those unintended consequences and collateral damage; they are also concerned about an independent government agency wielding such a great deal of power as it carries out a year-after-year whatever-it-takes approach. Supporters are much less concerned.
I have always had this problem with nominal GDP targets, inflation targets, and so forth. Ok, the Fed adopts your target. Now what? If nominal GDP doesn’t do what the Fed wants it to do, what should the Fed do about it? Talk more? (Monetary policy is starting to look more and more like foreign policy here).
. . .
Taylor, of course, would like the Fed limited to the instrument of short-term rates, and to follow the Taylor “rule” for setting them. But the principle is larger than that instance.
Like Cochrane and Taylor, I’m not happy with current policy, but I don’t believe they have the right answer. Let’s start with the fact that the Taylor rule is a sort of flexible inflation target, so it’s not clear to me why Cochrane would oppose inflation targeting and praise Taylor’s defense of the Taylor Rule. Any instrument-based monetary regime must have a nominal anchor, or else the price level becomes indeterminate. Of course there are some instruments (the price of gold, for instance) that do anchor the price level, but I doubt Cochrane favors a return to the gold standard.
If we’ve learned anything in the past few years it’s that the Taylor Rule (and indeed any regime based on an interest rate instrument) is a lousy system. It freezes up just when you need it most, at the zero bound. I like to compare it to a car that has steering that works fine, except that it locks up when driving on twisty mountain roads.
A much better system would be to use NGDP futures as the policy instrument, i.e. make dollars convertible into NGDP futures at a fixed price, which rises by roughly 5% per year. But that’s not going to happen anytime soon. So how can I defend recent policies like QE, as being better than nothing? One answer is that stock markets in the US and Japan love QE. Conservatives are supposed to believe that markets are efficient, so the stock market response must be telling us something. Now I suppose one could argue that stocks rose because of much higher expected inflation. But in fact (PCE) inflation has fallen to 1% in the US, and market indicators of inflation continue to show that market monetarists have been consistently right about inflation (over the past 5 years), and the rest of the conservative movement in America has been consistently wrong. Surely that counts for something? My guess is that the markets see more NGDP leading to more RGDP in the short run, and that’s why stock investors love QE.
To summarize; Taylor and Cochrane are right that there is a lot to criticize in current monetary policy. But the problem is not that central banks are targeting things like NGDP, rather the problem is that central banks are focusing on policy instruments, and are not targeting things like NGDP. We have monetary policy as a series of “gestures.” ”We’ll do this and that, and then see what happens.” A policy of NGDP targeting, level targeting, would provide transparency, as markets would know how much NGDP would rise over the next 10 years. The monetary base and interest rates should be set at a level where the market expects NGDP growth to be on target. Indeed John Cochrane has endorsed a slightly different market-based approach in previous posts.
The market’s are telling us that the “whatever-it-takes approach” is the right one, and this is why the US and Japan are now doing better than the eurozone. The markets don’t care how big the monetary base is; they care about NGDP. We need to focus on goals (hopefully NGDP level targeting) and let the policy instrument be the servant.
PS. Re-reading Cochrane I’m not sure he does oppose inflation targeting, perhaps he simply opposes inflation targeting regimes that lack a clear instrument rule. If so, I exaggerated our differences.
HT: Michael
PPS. Garett Jones makes an argument that seems related to Cochrane’s post:
So in many policymaking situations, more action means more uncertainty about the effects of the action. And if your goal is to be close to your target, then more uncertainty is a genuine cost of taking more action.
Hence, Brainard’s Conservatism Principle. Alan Blinder, formerly vice chair of the Fed, summed the Brainard Conservatism Principle this way when he applied it to monetary policy:
Estimate how much you need to tighten or loosen monetary policy to “get it right.” Then do less.
Actually you should do exactly as much as the markets think necessary to “get it right.” (It doesn’t matter what you think.) Period, end of story. The mistake people make is thinking about monetary policy is terms of more or less “instrument action.” There are two big problems with this worldview:
1. There are many policy instruments; the base, interest rates, exchange rates, etc. More of one might easily mean less of the other. I favor NGDP futures targeting, and hence would never change my preferred instrument at all, relative to the trend line.
2. The second problem is that many people (implicitly) assume that if all this QE hasn’t raised NGDP growth up to 5% or 6%, we’d need even more QE to get there. On the contrary, if a robust NGDPLT regime were adopted, at say 5%, then the demand for base money would be much less, and hence the Fed could get by with even less QE.
Rather than thinking in terms of “effort,” think of monetary policy as steering an ocean liner. It doesn’t take more effort to set the wheel at NE as compared to NNE. So you always want to set the wheel in such a fashion as to equate the forecast of the port you will reach, with your desired destination. Monetary policy is no different.
HT: Saturos