Friday, November 10, 2006

Inflation target dead?

I recently read a Merrill Lynch commentary that mentioned, somewhat off-handedly, that an officially sanctioned inflation target for the Fed is less likely with a Democratic congress. As I've said many times, I'm a big fan of inflation targeting for a variety of reasons. I think most people who are of the Milton Friedman school of monetarism are at least sympathetic to the idea.

Inflation targeting works for various reasons, but one of the primary reasons is wrapped up in rational expectations theory. That is, when people expect a certain level of inflation, they will act accordingly. For example, when negotiating wage contracts, or borrowing rates, the expected inflation level will influence the final figures. These actions will steer inflation toward the expected level.

If you believe in rational expectations, then expanding the money supply can't have any impact on real GDP growth. If the public knows the Fed is providing easy money, they will adjust their inflation expectations. So laborers get raises but firms raise prices all at the same rate, so no one is better off and inflation is higher.

Keynesians reject the notion that economic actors are all that rational. So let's say there is a glut of inventories in the economy at the time the Fed is expanding the money supply. Now consumers have more money but maybe firms don't raise prices right away and instead choose to reduce inventory. Had the influx of money-related demand not occurred, firms may have cut production in order to eliminate inventory, which reduces GDP. But because of the money expansion, the inventory is sold and production levels remain high.

I'm sure most people reading this are thinking both scenarios sound pretty reasonable. I'm more sympathetic to the monetarist perspective. In the second scenario, I agree you'd wind up with inventory reduction, but before too long the easy money would result in pure inflation, and that increased level of inflation would become ingrained in expectations. Now to bring inflation expectations back down, the Fed would need to conduct a painful round of tightening. So the short-term benefit of better GDP through easy money is more than offset by the need for severe tightening down the road.

But my opinion isn't the one that matters. If the people in congress, and the people advising them (like Paul Krugman) think more along the Keynesian line, then they will more often advocate monetary policy based on various economic figures, like capacity utilization and business inventories, not just core PCE. Ben Bernanke would then be in a political fight to get his inflation target, which not only would jeopardize his job should the Democrats take the White House, but could even impact the Fed's independence.

Bernanke can run a de facto inflation targeting Fed anyway. He makes a public announcement that he wants core PCE to be between 1.5% and 2.5%, and promises to do everything in his power to keep it there. Pretty much an inflation target eh? Why risk the political fight?

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