I’m enjoying Matt Rognlie blogging at his new place. He just wrote a post about what should be the target of the inflation target, linking to this paper by Greg Mankiw and Ricardo Reis. So what should be a target of an inflation target? Rognlie:
- The more responsive a sector is to the business cycle, the more weight that sector’s price should receive in the stability price index.
- The greater the magnitude of idiosyncratic shocks in a sector, the less weight that sector’s price should receive in the stability price index.
- The more ﬂexible a sector’s price, the less weight that sector’s price should receive in the stability price index.
- The more important a price is in the consumer price index, the less weight that sector’s price should receive in the stability price index.
Mankiw writes about his ideal target using that criterion and brought up an interesting historical story:
Our results suggest that a central bank that wants to achieve maximum stability of economic activity should give substantial weight to the growth in nominal wages when monitoring inﬂation…
An example of this phenomenon occurred in the United States during the second half of the 1990s. Here are the U.S. inﬂation rates as measured by the consumer price index and an index of compensation per hour:
Year CPI Wages
1995 2.8 2.1
1996 2.9 3.1
1997 2.3 3.0
1998 1.5 5.4
1999 2.2 4.4
2000 3.3 6.3
2001 2.8 5.8
Consider how a monetary policymaker in 1998 would have reacted to these data. Under conventional inﬂation targeting, inﬂation would have seemed very much in control, as the CPI inﬂation rate of 1.5 percent was the lowest in many years. By contrast, a policymaker trying to target a stability price index would have observed accelerating wage inﬂation. He would have reacted by slowing money growth and raising interest rates (a policy move that in fact occurred two years later). Would such attention to a stability price index have restrained the exuberance of the 1990s boom and avoided the recession that began the next decade? There is no way to know for sure, but the hypothesis is intriguing.
It’s things like this that make me worried about being creative with inflation targeting. No notable inflation in the economy and the only period of sustained wage growth in my lifetime – better get the central bank to choke that off immediately. Can some Republican officially propose “price stability and minimal wage growth” as the new dual mandate for the Fed?
There’s a story that goes around, Dean Baker loves to tell it, that Greenspan was under immense pressure from serious economists to raise rates when unemployment hit 5% in the late 1990s because inflation must be right around the corner. Unemployment was below a poorly-defined-empirically NAIRU, after all. Greenspan didn’t, unemployment went lower, there was no inflation and, say it with me, the United States experienced the only period of sustained wage growth I’ve seen in my years on this Earth. Here’s to some discretion with our targets and rules.
Chris Hayes mentioned this incident in his paper on the case for inflation:
The main competition to monetarism in the 1980s and 90s was not Keynesianism, which continued to fall out of favor, but a politically related but theoretically distinct theory, about the “non-accelerating inflation rate of unemployment” (NAIRU or natural rate for short). The natural rate partisans held that there was a “natural rate” of unemployment, the necessary amount of joblessness to allow labor markets to churn and function with maximal efficiency. If unemployment dropped below this boundary (generally believed to be somewhere in the neighborhood of 6 percent), inflation would spike. In the late 90s, the theory was put to the test. As unemployment dipped below 4 percent in the 1990s, panicked natural rate advocates urged the Fed to raise rates to stave off inflation. Greenspan, in possibly the single highlight of his tenure at the Fed, refused, and inflation remained at historic lows. So much for the natural rate.