Wednesday, October 13, 2010

Can the Fed come to its Senses?

At the last Fed meeting, somebody mentioned a target for the growth path of money expenditures.....

Participants noted a number of possible strategies for affecting short-term inflation expectations, including providing more detailed information about the rates of inflation the Committee considered consistent with its dual mandate, targeting a path for the price level rather than the rate of inflation, and targeting a path for the level of nominal GDP.
Last but not least?

I might also complain a bit about seeing money expenditure targeting as a means to raise short term inflation expectations (and so, lower real short term interest rates and the output gap.) The actual point would be to raise expectations of real sales, and so increased investment at any level of real interest rate as well raise expectations of employment, and real consumption expenditure. The increase in real expenditures should increase real output (reduce the output gap) and employment. That this might result in higher inflation is an undesirable side effect. While people expecting this unfortunate side-effect shouldn't count as a cost, generating such an expectation is hardly the point.

More importantly, a target for the growth path of money expenditures--if it is permanent--protects against any temporary inflationary impact from creating expectations of permanently higher inflation. Once money expenditures return to an appropriate target, persistently higher inflation would involve firms pricing themselves out of sales. Since firms would be motivated to avoid that sort of suboptimal behavior, expecting such inflation would not be rational.

Most fundamentally, the reason for targeting the growth path of money expenditure is that it provides the least bad macroeconomic environment for microeconomic coordination. Memoryless inflation targeting has proven a failure in the face of a large negative shock to monetary expenditures. Price level targeting would surely be a disaster in the face of any significant adverse supply shock and perhaps bubble prone if there were a favorable aggregate supply shock. Short term interest rate targeting has failed, once again, this time in the face of a severe financial shock that involved a shift away from holding more risky assets to holding safer assets.

It is time for something new.

Well, at least it is on the Fed's radar now.

HT to David Beckworth

P.S. OK, so Scott gets to be Frodo. I have always liked Pippin, and I am clearly not the faithful follower type, but Sam did become Mayor.


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