Strategic Briefing | 9.19.2011 | Debating Central Bank Policy

End the Fed’s Dual Mandate And Focus on Prices
John Taylor (via Bloomberg) | Sep 16
Some worry that a single focus on the goal of price stability would lead to more unemployment. But history shows just the opposite. A single mandate wouldn’t stop the Fed from providing liquidity, or serving as lender of last resort, or reducing the interest rate in a financial crisis or a recession. But it would make it more difficult for the Fed to engage in the kinds of discretionary actions that frequently have resulted in higher unemployment.

John Taylor defends a troublesome target
Marcus Nunes | Sep 18
In fact, inflation after 1982 exhibits substantially less persistence than in the previous years (see figure below) so that increases in inflation in one month are viewed as temporary. In other words, inflation is much less auto correlated so that lagged values of inflation provide little information about future inflation. As a result, unexpected movements (or innovations) in inflation no longer require a monetary policy response (which sits well with the argument that the fed funds can be a poor indicator of monetary policy).
This leads me to think that “inflation targeting” as the sole mandate for the Fed may not be a good idea. What propels the economy is nominal (or dollar) spending, so to achieve economic stability we should be concerned with “spending stability” along a target path.
It appears that the “Great Moderation” came about exactly because, even if unwittingly, Greenspan managed for the most part to keep spending pretty stable along a determined path… So no Professor Taylor, the proper single mandate should be “Spending Stability”, i.e. targeting NGDP.
From an American in London, Global Warnings
The New York Times | Sep 17
Governments are pushing austerity; bankers are hoarding cash; a recession looms in the United States and Europe. But Adam S. Posen has a solution: a shock-and-awe display of coordinated central bank attacks aimed at reviving sluggish economies. An American economist on the Bank of England’s monetary policy committee, Mr. Posen is no academic scribbler or lonely blogger, but someone inside the central banking establishment…
There is a certain tilting-at-windmills aspect to his crusade. The Fed will probably stop well short of the aggressive bond buying that Mr. Posen has advocated. Already, some Fed officials — and most Republican leaders, including the presidential hopefuls Rick Perry and Mitt Romney — believe that the Fed is at risk of rekindling inflation.
But that hasn’t stopped Mr. Posen from pressing his case. Earlier this month, he had lunch with Kiyohiko Nishimura, a deputy governor at the Bank of Japan, and Charles Evans, the president of the Federal Reserve Bank of Chicago. And, last Tuesday, he traveled to this small hamlet in southeast England to issue his most passionate cry yet. “I am here to warn policy makers in the United States, Europe, everywhere that we cannot take our foot off the pedal,” Mr. Posen said before a roomful of small-business leaders and bankers. “The outlook is grim — the right thing to do now is engage in more monetary stimulus.”
A Little Inflation Can Be a Dangerous Thing
Paul Volcker (via NY Times) | Sep 18
It’s not yet a full-throated chorus. But remarkably, at least one member of the Fed’s policy making committee recently departed from the price-stability script.
The siren song is both alluring and predictable. Economic circumstances and the limitations on orthodox policies are indeed frustrating. After all, if 1 or 2 percent inflation is O.K. and has not raised inflationary expectations — as the Fed and most central banks believe — why not 3 or 4 or even more? Let’s try to get business to jump the gun and invest now in the expectation of higher prices later, and raise housing prices (presumably commodities and gold, too) and maybe wages will follow. If the dollar is weakened, that’s a good thing; it might even help close the trade deficit. And of course, as soon as the economy expands sufficiently, we will promptly return to price stability.
Well, good luck.
Some mathematical models spawned in academic seminars might support this scenario. But all of our economic history says it won’t work that way. I thought we learned that lesson in the 1970s. That’s when the word stagflation was invented to describe a truly ugly combination of rising inflation and stunted growth.
My point is not that we are on the edge today of serious inflation, which is unlikely if the Fed remains vigilant. Rather, the danger is that if, in desperation, we turn to deliberately seeking inflation to solve real problems — our economic imbalances, sluggish productivity, and excessive leverage — we would soon find that a little inflation doesn’t work. Then the instinct will be to do a little more — a seemingly temporary and “reasonable” 4 percent becomes 5, and then 6 and so on.
What we know, or should know, from the past is that once inflation becomes anticipated and ingrained — as it eventually would — then the stimulating effects are lost. Once an independent central bank does not simply tolerate a low level of inflation as consistent with “stability,” but invokes inflation as a policy, it becomes very difficult to eliminate.
Rearranging the Deck Chairs
Tim Duy | Sep 18
Here we are, again staring down the barrel of an FOMC meeting while deeply entrenched in a subpar equilibrium, with output well below the pre-recession trend and unemployment stuck in the high single digits. What will the Fed bring to the table this time around? Considering the magnitude of the economic challenge, expectations are low: A modification of the FOMC statement to reflect an increasingly pessimistic outlook couple with some version of “Operation Twist,” an effort to reduce longer-term interest rates by extending the duration of the Fed’s portfolio of Treasury securities. There is an outside change the Fed lowers interest on reserves, but I view that as unlikely at this juncture. Even more unlikely is another round of quantitative easing. I don’t think there is much appetite at the Fed for additional asset purchases given the inflation numbers and the stability of longer-term inflation expectations relative to the events that prompted last fall’s QE2…
Larry White on the International Gold Standard
Bill Woolsey | Sep 15
Over on Free Banking, Larry White linked to an article where he advocated the international gold standard in combination with free banking…
While I favor free banking, I don’t favor an international gold standard. Rather, I favor a monetary regime that stabilizes the growth path of nominal GDP. This sometimes requires printing money, and sometimes the floating exchange rate depreciates, resulting in more exports.
If we consider a situation where some error has resulted in inadequate money creation so nominal GDP falls below target, the result would likely be slower growth or even reduced real expenditure, real output, and employment. In other words, this error would lead to a recession.
Fixing the error, and returning nominal GDP back to its target growth path, would involve expanding the quantity of money, which could involve a depreciation in the exchange rate, and an expansion of exports (and in the demand for import competing goods.) This would be one avenue by which the expansion in the quantity of money would increase nominal expenditure back to target, which would lead to a recovery of real output and employment.
More importantly, it is quite possible that preventing the exchange rate depreciation would require that less money be created, so that nominal GDP would remain below its targeted growth path. Given that lower growth path for nominal GDP, recovery would require that prices and wages shift to a lower growth path, so that real expenditure and output can return again to their previous growth path.