Central bankers from around the world meet in Jackson Hole, Wyoming, starting Thursday for the Federal Reserve’s annual symposium. They have a lot to discuss; more, it’s safe to say, than they would like.
The experience of the past several years has assaulted the core of what central bankers once took for granted about their role. A comprehensive rethink is required. At the top of the list is a sensitive subject: How should central banks balance the goals of low inflation and low unemployment? The question is harder than economists used to think, and it’s an uncomfortable one for the Jackson Hole crowd because it’s about politics as much as economics.
Before the most recent recession, the question had mostly been set aside. Economists decided that the goals of price stability and high employment weren’t really in conflict. In 1969, Milton Friedman and Edmund Phelps showed, in a seminal finding of modern macroeconomics, that there’s no long-run trade-off between inflation and output. That is, tolerating higher inflation doesn’t buy you faster economic growth.
What a convenient finding that was for central banks. It meant they could be told to keep prices stable, and then be left alone to get on with it. Independent central banks would be better at keeping inflation low than would those under the political control of finance ministries, often tempted to print money to pay for their programs. And if low inflation didn’t hurt growth, why not set them free?
This thinking guided the design of the European Central Bank in the 1990s. European governments gave it a primary goal of price stability and shielded it from government interference. They told the ECB never to print money to buy public debt. Many other central banks had their rules tweaked to similar effect.
The rules in the U.S. haven’t been so clear-cut. The Fed has a dual mandate of stable prices and maximum employment, and the latitude to decide what that means. This wider discretion is exactly what many of the Fed’s conservative critics in Congress now object to. They want the narrower focus on stable prices that is written into many other central banks’ rules, and then some.
The recurring vogue for the gold standard -- the Republican Party is calling for yet another commission to examine the idea -- is all about denying the Fed discretion. With a truly fixed exchange rate, monetary policy is abolished: Fixing a designated price (under a gold standard, the price of gold) puts the Fed on autopilot.
Many U.S. conservatives also want the Fed to be more strictly audited. Republican presidential nominee Mitt Romney just backed this idea. His running mate, U.S. Representative Paul Ryan, wants tougher audits, a single anti-inflation mandate and, ideally, a dollar pegged to the prices of commodities. Again, the aim is to tie the Fed down.
This anti-inflation obsession borders on derangement. Inflation is very low -- so low that deflation is a
Contrary to what gold bugs and other Fed-bashers say, the Fed’s dual mandate and its policy of quantitative easing -- buying bonds to nudge down interest rates -- have been vital strengths, not weaknesses. They have helped to support demand and bring unemployment down, albeit slowly. Fiscal paralysis in Washington made the Fed’s unorthodox measures all the more necessary. Far from being reckless, the Fed has been too timid and needs to embark on the third round of QE that Chairman Ben S. Bernanke keeps hinting is on the way.
Consider the European alternative. The ECB is pushing the euro area back into recession with its preoccupation with low inflation plus a reluctance (or inability) to use QE.
But there’s a catch, and it’s a big one. If the short-term trade-off between inflation and unemployment is real, and central banks have to strike a balance between the two -- putting aside concerns about inflation until the recovery is on a surer footing -- how can you say central banks should be shielded from political interference? If they are making political choices, they can’t expect to stay above politics. There’s no easy answer, which is why the discussions at Jackson Hole will probably shy away from the question.
We suggest looking at an old idea that is again attracting attention among monetary economists. Recast the target that the Fed and other central banks are told to follow. Instead of a target for low inflation plus an additional primary or secondary target of high employment, focus on the money value of output -- nominal gross domestic product unadjusted for inflation. This combines prices and output in a single number.
Suppose the target was 5 percent. Over the longer term, with the economy growing at 2 percent or a little more, inflation would be 3 percent or a little less, similar to the inflation targets most central banks (including the Fed) have adopted. Here’s the advantage: In the short term, the Fed would be on target if the economy were growing at 5 percent and inflation were zero, or if the growth were zero and inflation were 5 percent.
In other words, the system would call for faster-than-normal growth when inflation is too low, and faster-than-normal inflation when the economy is in a slump. Setting a nominal GDP target wouldn’t be telling the bank to choose between so much inflation and so many jobs, so you could still grant operational independence.
It’s not quite so tidy, of course. The bank would still have to decide how quickly to bring demand back to target if it overshot or undershot, and this could be politically contentious. Targeting nominal GDP raises technical issues, including how to specify the mandate. The idea has serious academic credentials, but some scholars have expressed doubts.
We think it’s worth a careful look, and we’re convinced of one important advantage: This approach would make the bank’s actions easier to understand and explain.
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