Central Banks’ Inflation Objective

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The cornerstone of mainstream macroeconomists’ advice on monetary policy is the first and foremost emphasis on low, stable inflation. Full employment, if considered at all, is explicitly secondary. That guidance is dead wrong. The only specification of stabilization objectives that makes sense is full-employment targeting that is at least coequal with low inflation.

The necessary diminution of the dominant status of the inflation objective largely rests on three interrelated characteristics of highly specialized economies:

  • Nominal demand disturbances interact with meaningful wage rigidity (MWR) to produce same-direction changes in employment, output, and income. Given that general-market-equilibrium macro modeling can accommodate neither MWR nor involuntary job loss (IJL), mainstream analysis must downplay the damage caused by cyclical unemployment. The purpose of the mainstream emphasis on low inflation is not to manage the range of welfare loss from instability. It is instead to protect human capital and reputations rooted in micro-coherent, market-centric models that cannot capture actual unemployment and business cycles.
  • Employment and inflation goals do not conflict in any way that is problematic to policymakers. Generalized-exchange modeling microfounds the manageable relationship between the two stabilization targets, effectively associating policy-relevant inadequate employment with weak inflation and policy-relevant excessive inflation with robust employment.
  • Inflation alone provides information that is neither sufficiently timely nor sufficiently indicative of real-side cyclical behavior to support the effective monetary management of employment.

Fundamental meta-externality. In the two-venue macro model class, instability is always associated with broad market failure. That breakdown is Keynesian in nature, rooted in the interaction of rational price inflexibility and nominal demand disturbances. Large-scale market failure generates an important meta-class externality. The existence and nature of employment/ output loss caused by weakening total nominal spending have been made consistent with continuous general decision-rule equilibrium in the GEM Project’s intuitive generalization of exchange from the marketplace to the workplaces restricted by costly, asymmetric information and routinized jobs. (Chapters 2 and 3) Demand instability induces the lion’s share of business-cycle welfare loss – a fact that cannot be ignored in the specification of central-bank objectives.

Time-inconsistency. The Kydland-Prescott time-inconsistency theorem is frequently, incorrectly used to support the dominance of the central bank’s inflation goal. Upon examination, the famous theorem is little more than a misleading artifact of the micro-coherent, market-centric model class. (Chapter 4) Competent central bankers know that they can identify when to emphasize employment and when to emphasize inflation. The Fed knew to emphasize jobs and output in the Great Recession and knows today, as the economy has moved close to full employment, that interest rates must be normalized.

In an important related issue, the consensus analysis of the famous stagflation decade (beginning in the 1970s) that singles out the failure of Federal Reserve’s low-inflation credibility as the principal cause of the macro debacle is also wrong. Stagflation became the cause célèbre for anti-Keynesian insurgents and has long been exhibit A for assigning primary status to inflation control in stabilization policymaking. It turns out that a micro-coherent explanation of stagflation that correctly identifies the causal forces at work is not possible absent the generalization of price-mediated exchange. (Chapter 4)

Limited information. Mainstream theorists additionally argue that singular central-bank attention to inflation is proper because aggregate price movements adequately inform policymakers about the behavior of employment as well other important real-side economic indicators. The GEM Project has demonstrated that assumption, in its various forms, to be another, albeit particularly dangerous, artifact of micro-coherent  market-centric macroeconomics.

The Project has made substantial progress on reconciling large-establishment product pricing with the available evidence. Once labor prices are recognized to be in chronic, time-varying market disequilibrium, rational product pricing is best captured by cost-markup. Inflation then responds sluggishly to altered market conditions. Generalized-exchange analysis is consistent with the evidence that many product prices are sticky over business cycles, much more loosely related to the labor market than suggested by the natural-rate hypothesis. In highly specialized economies, inflation alone provides inadequate information to support the effective instability management. In particular, inflation monitoring is an obviously poor substitute for directly tracking the behavior of job loss and unemployment.

The GEM message is clear. Inflation cannot play the leading-indicator role in real-side stabilization. A predominate role for inflation in making sense of what is happening on the real-side of the economy is, to reiterate, a misleading artifact of market-centric general-equilibrium thinking. In two-venue modeling, properly targeted employment and inflation are each necessary on their own terms. Stabilization policymakers principally seek to manage employment consequences of adverse stationary demand disturbances (SDD), or more urgently SDD→NDD (nonstationary demand disturbances), in order to reduce the welfare cost of involuntary job and income loss, not to reduce real distortions associated with a lower level of price inflation. To assert otherwise is dumb.

Transparency. Moreover, a central-bank focus on inflation, declared publicly and promulgated internally, makes the real-time stabilization policymaking that does occur hopelessly nontransparent, harming its capacity to be effectively communicated and to garner credibility. The problem is that the single-goal policy is not descriptive of actual behavior. In the illustrative circumstances of late 2008, with contracting spending and employment not correspondingly reflected in the behavior of price and wage inflation, competent central banks shifted their operational attention to the active monitoring and stabilization of employment and output. It is not useful to enshrine, in the public mind, single-mandate policymaking that over the plausible range of circumstances is not, and should not be, practiced.

Blog Type: New Keynesians Chicago, Illinois



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