The GEM Blog’s three-month series on policy implications of generalized-exchange macroeconomics has yet to consider product-price inflation, focusing instead on the cyclical behavior of employment and output. My emphasis is well outside the macro mainstream that has held for a generation.
The keystone of the academy’s monetary-policy advice has long been the primacy of inflation targeting. In consensus thinking, real-side stabilization objectives are explicitly secondary. That guidance is flat-out wrong. It is especially harmful in that it has provided support for a wave of political criticism of the employment mandate in the aftermath of the 2007-09 Great Recession. In late 2010, prominent Congressman (now Indiana Governor) Michael Pence introduced legislation requiring the Fed to focus only on inflation. In his statement announcing the bill, Pence implicitly invoked the presumed absence of meaningful wage rigidity (MWR), an unhappy fact of consensus coherent macroeconomics: “The Fed can print money, but they can’t print jobs. Printing money is no substitute for sound fiscal policy and we ought to be looking to the Congress to embrace the kind of policies that will get this economy moving again.” Rep. Paul Ryan, the unsuccessful 2012 Vice-Presidential candidate and now House Speaker, and Sen. Robert Corker, an influential coalition-building member of the Senate Banking Committee, were among the supporters of eliminating the dual mandate. Even James Bullard, then President of the Federal Reserve Bank of St. Louis, joined the chorus.
By contrast, the GEM Project, especially its coherent modeling of extreme instability, demonstrates the importance of stabilization authorities’ trend real-side objective. (Chapters 6 and 10) Employment/output targeting is shown to have played a crucial role the 2008-09 total-spending meltdown and subsequent recovery. Investors and lenders were uncertain about the reliability of the trend real-side stabilization goals, becoming rationally inactive while awaiting credible market bottoms to emerge. Rational inactivity pushed demand into a downward spiral. The central macrodynamic issue was the capacity of stabilization authorities to halt and reverse rapidly contracting total spending and hemorrhaging job loss. Federal Reserve policymakers properly deemphasized their nominal target.
The Project’s case for Fed targeting of at least coequal real and nominal regimes is further supported by three interrelated characteristics of highly specialized economies.
Inadequate information. Some mainstream theorists argue that aggregate price movements satisfactorily inform policymakers about real-side behavior, making a singular focus on inflation sufficient. That inflation provides adequate timely information on the real-side behavior of the U.S. economy is no more than a figment of economists’ imagination. Ample evidence indicates many product prices are sticky over business cycles, much more loosely related to conditions in the labor market than predicted by the natural-rate hypothesis. Indeed, given that experience consistently demonstrates the practical policymaking relevance of real-side evidence, isn’t advice to marginalize it reckless no matter what model is used?
In the second half of 2008, a few FOMC members cited the behavior of inflation in support of their opposition to aggressive Fed intervention in total spending. They argued that the relative stability of product-price inflation in monthly surveys indicated that exceptional intervention was unnecessary. Somehow, they convinced themselves to ignore that the minor movement in the price data contrasted sharply with the alarming data showing mass layoffs, rapidly contracting output, and shrinking demand. The naysayers were properly ignored. Today, their contribution is limited to illustrating the folly of taking seriously the primacy inflation targeting.
Objective compatibility. Nominal and real targets do not conflict in any way that is operationally problematic for policymakers. Evidence as well as state-of-the-art macro modeling inversely associate employment and inflation. Rigorous analysis of stagflation decade, featuring the substantial impact of its price-wage-price spiral on the interindustry wage structure and labor-market and production efficiency, enriches rather than contradicts the manageable interaction between real and nominal goals. Available evidence demonstrates stagflation macrodynamics to be badly understood as an inherently nominal phenomenon rooted in central-bank abandonment of its commitment to low inflation. (Chapter 4)
The practicality of the Kydland-Prescott time-inconsistency theorem is little more than an artifact of stabilization-irrelevant DSGE modeling. In 2008-09, the Fed understood the inadequacy of the mainstream model, wholly focusing its efforts on the Early-Keynesian strategy of halting and reversing the collapse in nominal demand. Central-bank leadership also understood that the real-side emphasis did not lessen their commitment to low trend inflation. The nominal objective was not contemporaneously relevant. Bernanke was always eager to explain how the liquidity build-up could be neutralized without triggering inflation.
Why emphasize inflation? The third characteristic of highly specialized economies helps explain the curious commitment of mainstream macroeconomists to the primacy of inflation targeting. At the core of the GEM Project’s instability macrodynamics, nominal demand disturbances interact with fully microfounded MWR to produce real-side consequences, featuring opposite-direction movement in involuntary job loss and unemployment along with same-direction changes in employment and output. (Chapter 6) Given consensus DSGE modeling cannot coherently accommodate MWR or otherwise suppress wage recontracting, mainstream theorists have great incentive to downplay nominal-to-real causality in their cyclical narrative, pushing aggregate demand and forced joblessness into the shadows. Inflation becomes, by default, the star of the show.
I understand that cutting-edge model-builders, attempting to get their ducks in a row, are given substantial latitude to ignore crucial facts. Macro theorists, however, go too far when they use their problematic analysis to advise central banks to emphasize inflation targeting. Stabilization authorities must adhere to a higher standard of real-world consciousness.
A final word. A fourth point is more subtle but still important. Monetary-authority emphasis on targeting inflation, declared publicly and promulgated internally, makes real-time stabilization policymaking hopelessly nontransparent, limiting its capacity to be effectively communicated and therefore to garner credibility. The problem is that inflation-targeting primacy is not descriptive, when push comes to shove, of actual policymaker behavior. For example, in the Great Recession’s circumstances of rapidly contracting spending and employment not correspondingly reflected in the behavior of price inflation, the central bank properly shifted its operational attention to the stabilization of total spending, employment and output, supported by close monitoring of real-side indicators. Targeting its real-side, not nominal, objective was primary. A critical message of the GEM Project is the damage that can result from enshrining, in the public mind, a fictional primacy of the Fed’s nominal objective.
Blog Type: Policy/Topical Saint Joseph, Michigan
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