Thursday, February 18, 2010

Woodford, Interest Rate Targets, and Inflation

I have been reading Michael Woodford's Interest and Prices. He describes his approach as "neo-Wicksellian," and spends a good bit of time discussing "cashless payments systems." Woodford also insists that monetary policy should be based on implementation of rules.

I have always been a fan of Wicksell, and "cashless payments systems," have been one of my passions. Most importantly, my basic understanding of "monetary policy" involves the appropriate rules for the monetary constitution.

However, the focus of Woodford's book is explaining and justifying a central bank policy for manipulating the overnight interbank lending rate.
"I have argued that the central problem of the theory of monetary policy is to provide principles that can be used in selecting a desirable rule for setting a central bank's interest-rate operating target."
I believe that the Federal Reserve should stop targeting the federal fund rate. I won't dispute Woodford's claim,
"it does not seem at all natural or useful to try to explain the predicted paths of inflation and output as consequences of the implied path of the money supply. Instead, it proves possible to discuss the determinants of inflation and output in a fairly straightforward way in terms of the coefficients of an interest rate rule."
or even,

"optimal policy can be conveniently represented in terms of specification of exactly that sort."

My complaint is that Woodford's framing of the issue is having an impact on the proposed goals of monetary policy.

It is bad enough that we have put up with a two percent trend rate of inflation for the last two decades. But now, Oliver Blanchard, whose blurb on the back of Woodford's book compares it to Patinkin's Money, Interest and Prices, is calling for a four percent trend inflation rate.

Why? In the end, it comes down to the following statement from Woodford,
"My focus on the choice of an interest-rate rule should not surprise readers familiar with the current practice of central banks. Monetary policy decision making almost everywhere means a decision about the operating target for an overnight interest rate, and the increased transparency about policy in recent years has almost always meant greater explicitness about the central bank's interest-rate target and the way interest-rate decisions are made."
Perhaps we should instead take Milton Friedman's approach. I don't mean a target for the growth rate of some measure of the quantity of money. But instead, to consider that maybe central bankers have gotten it wrong. If the central bankers penchant for setting overnight interbank interest rates means that the rest of us must put up with 4 percent inflation, then perhaps the central bankers should change their ways.

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