Mark Thoma has an interesting article on the dilemma facing the Fed: does it respond to rising inflation or the anemic economic recovery? On the one hand, the Fed is concerned about maintaining its inflation fighting credibility and its independence from Congress. Thus, it wants to be seen as vigilant on the inflation front. On the other hand, it does not want to undermine the economic recovery, as sluggish as it is. What will it do? For a number of reasons, Thoma believes the Fed will err on the side of fighting inflation. This is unfortunate because any honest, fact-based assessment of the economy will show that long-term inflation expectations are well anchored, money demand remains elevated, and there remains much economic slack.
Now no one wants to see the the return of 1970s-type inflation. But what would be appropriate currently is some catch-up growth in nominal spending (and by implication inflation) to bring nominal income back to trend. Prior to the recession, households and business made many economic decisions based on an expectation of that nominal income would continue growing at about the same it had over the past few decades. As is well known, the growth in nominal income collapsed in late 2008, early 2009 and has never recovered. Consequently, those past decisions are now hindering a robust recovery.
What is needed then is a monetary policy rule that is systematic and predictable, but at the same time flexible enough to allow nominal spending to return to its trend when it falls off . There is a name for this: NGDP level targeting. Note that this approach, if widely understood, would make it easy for the Fed to have some higher inflation during the catch-up stage while keeping long-run inflation expectations anchored. Not only that, such a rule would also anchor nominal spending expectations and thus make it unlikely that there would be a collapse in nominal spending in the first place. This is such a no-brainer! If Congress really wants to reform the Fed this is how it should be done.
P.S. A price level target would also allow for some catchup inflation, but because of how it would handle supply shocks it is better to go with a NGDP level target.
Originally published at Macro and Other Market Musings and reproduced here with permission.