Why aren’t we using monetary policy to stimulate aggregate demand?

My NYT column today is about why we can't move to a three percent inflation target (which I favor, at least for some number of years) and how we might make the leap.  Excerpt:

…if the Fed announces a commitment to a higher inflation target but fails to establish its credibility, it will have shown impotence. It would be a long time before the Fed was trusted again, and the Fed might even lose its (partial) political independence. All of a sudden, the Fed would end up “owning” the recession.

Part of the credibility problem stems from the political environment, especially in Congress. Imagine the day after the announcement of a plan for 3 percent inflation. Older people, creditors and workers on fixed incomes – all connected to powerful lobbies – would start to complain. Republicans would wonder whether they had found a new issue on which to campaign, namely, opposition to inflation. And Democrats would worry about what position to take. Presidents of some regional Fed banks would probably oppose the policy publicly.

…The Fed lost some of its political independence during the financial crisis. It undertook major rescue operations in conjunction with the Treasury, and these bailouts proved extremely unpopular. Congress has taken a closer look at Fed operating procedures and will engage in a one-time audit of the Fed’s emergency lending. When it comes to inflation, the Fed cannot easily turn to Congress and simply ask to be trusted.

This is the sad side story of our financial crisis: especially when it comes to financial matters, a great deal of trust has been lost. There is the prospect of a free lunch right before us, yet it is unclear that we will be able to grab it.

…In failing to push harder for monetary expansion, is Mr. Bernanke a wise and prudent guardian of the limited discretionary powers of the Fed? Or is he acting like a too-hesitant bureaucrat, afraid to fail and take the blame when he should be gunning for success?

A few points:

1. For reasons of space, I could not note that the so-called "robust Reagan recovery" had price inflation of over four percent a year.  Many conservatives shy away from recognizing this.

2. Three percent inflation also would help the currently impossible state of the real estate market, by lowering the real value of debts.

3. I do not mean to discriminate against Scott Sumner's nominal gdp idea, but it is easier to explain an inflation rate target to a public audience.  Here is my earlier column on Scott.

4. Maybe we are in a new political economy equilibrium where each government agency is given "one shot" at a problem.  Treasury had its one shot with the stimulus plan.  The Fed had its exotic monetary policy operations and deal-making during the crisis.  Maybe in bad times voters aren't happy no matter what, and no one is allowed to try twice.  We have not yet thought through the political economy of this scenario.

5. If the Fed can't make the commitment today, when did it go wrong?  Perhaps at the peak of the crisis, when it was operating with a high degree of discretion, and various radical actions were viewed as justified, it should have announced that, to complete recovery, the three percent price inflation commitment would commence after the dust had settled.  That would have required Magnus Carlsen-like levels of foresight, however.  If nothing else, Bernanke may not have realized that some version of #4 was operating.

6. Contra Mark Thoma, I am not so worried about time consistency problems, provided that Congress supports the Fed.  As long as the economy is weak, it's in the Fed's interest to keep up the three percent inflation.  If people know that in better times we will eventually settle back to two percent inflation, I don't think this undercuts the whole idea.

7. It remains instructive to read Bernanke's 1999 Japan piece, for instance:

BOJ officials have strongly resisted the suggestion of installing an explicit inflation target. Their often-stated concern is that announcing a target that they are not sure they know how to achieve will endanger the Bank’s credibility; and they have expressed skepticism that simple announcements can have any effects on expectations. On the issue of announcement effects, theory and practice suggest that “cheap talk” can in fact sometimes affect expectations, particularly when there is no conflict between what a “player” announces and that player’s incentives. The effect of the announcement of a sustained zero-interest-rate policy on the term structure in Japan is itself a perfect example of the potential power of announcement effects.

With respect to the issue of inflation targets and BOJ credibility, I do not see how credibility can be harmed by straightforward and honest dialogue of policymakers with the public.

Maybe I'm too Straussian or too Freudian here, but I read him as trying to promote the commitment, without being totally sure it is possible; note the "distancing" language at the critical points of the argument.  I believe Bernanke wrote this next part before he completely understood the incentives of bureaucracies to conserve information:

But if BOJ officials feel that, for technical reasons, when and whether they will attain the announced target is uncertain, they could explain those points to the public as well. Better that the public knows that the BOJ is doing all it can to reflate the economy, and that it understands why the Bank is taking the actions it does. The alternative is that the private sector be left to its doubts about the willingness or competence of the BOJ to help the macroeconomic situation.


In other words, having stolen as much as you are comfortable stealing from the taxpayers, we should now move on to stealing from the savers.

Older people? Creditors? Workers on fixed incomes? Wait a minute...

Workers are, by definition, participating in the wage market. Wages go up during inflationary times. "Spiral" was commonly used, in my youth.

Most creditors would be much happier with repayment in inflated dollars than outright default... which is what really is driving debt levels down, not consumer savings. See this WSJ article:

Older Americans get about 3/4 of their income from Social Security and wages, both of which rise with inflation. Ditto with the value of the house they live in, and they can move their investments to TIPS. That leaves only their fixed pensions to whine about... a small slice of the retirement pie, and getting smaller.

Inflate away. I don't think the Fed will find many complainers.

So, Tyler believes in a free lunch.

Also, in the depths of the 80-82 recession, the rate of inflation was falling throughout, not being juiced higher by the Fed. Indeed, by 1986 the annual rate had fallen to less than 1.5%, and then rose into the 1990-1991 recession.

In any case, show me a central bank that really has the ability to set a target of 3%, or 4%, and keep it there with anything other than blind, dumb luck.


Why didn't you mention a level targeting rather than an inflation rate? Level targeting is far, far superior.

Second, why make it sound so hard to technically create inflation? "Of course, if no one believes the Fed’s commitment to price inflation, spending and employment will not go up. The plan will fail, and people will view their skepticism as vindicated." Massive increases in cash balances will eventually create inflation. These rational expectations game theory Krugmanesque models are really being taken too far. Does anyone really doubt that if cash balances in the average American pocket increase to $1,000,000 that we won't have inflation? Didn't we just see Japan intervene in the currency markets *unsterilized* and the Nikkei jumped 2.4%? Did the central bank suddenly convince stock traders to put on happy faces?

Monetary policy really isn't that complex!

How has monetary policy not been used? Didn't the Fed print up more money than ever before recently?

So essentially we reward the imprudent by punishing the prudent. Oh wait a minute we're already doing that...

I'm really confused. Outside of the official announcement that Tyler proposes, what ammunition does the Fed have left? The Fed can't lower rates any more. Can the Fed literally just print money and hand it out with no one having to pay it back?

"I'm really confused. Outside of the official announcement that Tyler proposes, what ammunition does the Fed have left? The Fed can't lower rates any more. Can the Fed literally just print money and hand it out with no one having to pay it back?"

Talking about rates is a language trap. The Fed can print money and use it to purchase bonds.

Trust has bee lost in ... academic economists.

You guys have been exposed by Taleb and White and Colander and others as fake scientists who in great measure are the architects of the Bush/Obama depression.

You told us there was no housing bubble. You told us we could "measure risk" and limn it with rocket science math. You told you'd figured out macroeconomics and we we in the midst of an unending great moderation.

Give us a break.

We don't trust you.

The Fed back in late 2008 drove down the M1 money multiplier from about 1.6 to less than 1. They did this by paying banks to hold on to their reserves. THIS IS CONTRACTIONARY!!!

What the US economy needs most are two things: fewer over-priced homes (in nominal mortgage value), and more jobs. Yes to 3% inflation! Best way, among most bad choices*, to get home prices back in line.

But what policy to use? More gov't spending, or more tax cuts?
What is needed is more tax cuts (Brad DeLong says he favors even them, now! tho I don't believe it for real.), for corporations and small businesses; or some way to get the "new money" to the private, peaceful market. Not the force based gov't sector.

Not all inflation is equal!
Again I suggest Tax Loans -- let corporations and businesses borrow the amount they paid in taxes the prior year, to be repaid starting no sooner than a year (possibly later), at an adjustable 0% interest rate to rise no faster than 0.25% per quarter, no sooner than a year after taking out the loan.

Such a program would be better than printing cash and helicopter drop -- but such a cash drop is better than TARP or Stimulus II.

(*since the gov't failure of Fannie & Freddie that supported giving poor people loans to speculate on house investments.)

This:"the prospect of a free lunch right before us", is this 'lunch', not at the expense of those foreign interests which hold dollar related assets. If so, would inflating down the debt not be seen internationally as a shirking of the responsibility for the current economic circumstances and shifting the resulting consequences onto the shoulders of innocent parties? Has anyone consulted with the oil producers to test what their reaction to a devaluing dollar might be? Presumably, oil goes up when the dollar goes down so it would seem critical here to know how OPEC&Co feel about sharing in the responsibility for the current downturn.

Plus, wage inflation has lost ground to price inflation for decades now. So, assuming that exports must rise to solve our unemployment issues, would it not be likely that increasing global competition would cause wages in the US to lag even further behind inflating prices? Have investors decided to relinquish the benefits of the 'demographic dividend' as part of some secretive effort to support their fellow citizens? Perhaps I am unaware of something here but the concept of inflating our way out of this mess seems to have some very significant shortcomings.

"There is the prospect of a free lunch right before us..."

In what way is inflation a free lunch? There are winners and losers. Just as there would be winner and losers if you raised taxes, or cut spending, or danced on the moon.

What I find remarkable about Anglo-Saxon economics is the disdain which both its right and left regard savers.


Yes, yes, there's no difference between the two parties, we might as well not vote, on and on. I appreciate the frustration, but I have no patience for the additional step of waving away the substantial differences in policy behavior between the two parties. It's an abdication of our responsibilities as citizens to understand the issues and the stakes more deeply than the catchphrases that roll so easily off the tongue.

To take but one example, if the two parties were truly equivalent, Wall Street wouldn't be massively shifting its donations to Republicans right now. (Who, among other things, are apparently once again gunning to dismantle Social Security, which isn't exactly an empower-the-rich program.)

From Chris D:

Wall Street wouldn't be massively shifting its donations to Republicans right now

Left unanswered is why the money has to "massively" shift at all if Republicans were Wall Street's best friends in the first place. Were they wasting their money giving it to Democrats?

The Fed should deposit a monthly stimulus payment into the account of everyUS resident. The amount can be varied until we hit 3% inflation. Printing money is justified provided we deliver to people, not banks.

"That getting people back to work part is the free lunch."

What's free about it? You may pay for it in the future, as instigating inflation may cause people to save less in the future with negative effects on the economy down the road. It's just like raising taxes to pay for government jobs; it's free now in the same way, because, while some groups are negatively effected and others are positively effected, unemployment decreases; but taxes may effect behaviour and have negative economic effects in the future.

I doubt there are any free lunches to be had in macroeconomics; it's about trade-offs, either in the present between different groups, or between the present and the future. And an economist who thinks he has detected a free lunch, should try to find the error in his reasoning, because there almost surely is one.

I was going to say what axiom above me said. What instrument do you and Sumner propose that the Fed use? Otherwise it's just cheap talk, given the serious time-consistency problems that the Fed faces. Say that there's a 5% fall in the price level; would you really think that the public or the Fed would want +8% inflation to get to the old price level path? The Woodford-Eggertsson approach involves the Fed giving up independence and agreeing to deflate the public debt over the very long run if it gets too high in real terms (which one can argue was in place from 1933 through 1952). There'd have to be a mechanism like this in place for a price level path to be credible.

Prof. Cowen, maybe this is a good time to ask you a question I've been saving: What are the long run consequences of a 0% or negative return on savings? We already have a lost decade of stock returns coupled with 0.01% money market rates. If we were to induce a negative savings rate through inflation, what would the consequences of lower savings be? Surely we can't have a successful economy in which borrowing is subsidized and saving is penalized over long time frames -- or can we?

And why are people openly advocating more inflation now? Is there any economist advocating that the government target a higher rate of unemployment?

I've pointed this out elsewhere, but Harry Truman devoted a good part of one of his messages to Congress on the steps the government was taking to deal with rising house prices, which were seen as a terrible thing, in making it more difficult for returning World War II veterans to establish households. For some time now, keeping house prices high has been a government objective. Rising house prices translates into higher property taxes, directly for homeowners and indirectly for renters. But it is normal now for "conservative" and pro "free market" commentators to argue in effect for people to pay more of their income in property taxes.

Same with pro-inflation arguments. When did respected mainstream commentators start arguing that the government should be actively trying to make people poorer?

the so-called "robust Reagan recovery" had price inflation of over four percent a year.

And still couldn't inflate asset prices enough to prevent a credit crisis, a real estate price crash that required a $125B bank bailout by Bush to clean up the problem that Reagan refused to deal, with because his advisors claimed the market would do it. The cost of cleaning up from the Reagan financial crisis cost taxpayers as much in real terms as TARP has.

Prof Cowen

It is one thing to have inflation that was left over from the debacle of the 70s and quite another to target a 3% inflation rate to "solve problems". The latter is called theft.

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