When paradigms collide

Nathan Kocherlakota certainly created a blogstastic firestorm with his statement that we need to raise interest rates to avoid deflation (Here is a good round up from Economist's View).

In a strange way, I think this can be related to Scott Sumner's multi-year hammering of the argument that money is indeed too tight.

Sumner favors the Fed targeting nominal GDP; it is not clear to me what Kocherlakota favors targeting.

If the Fed directly targeted a 5% inflation rate and did so successfully, two things would happen. First, we would avoid deflation. Second, interest rates would rise.

If the Fed directly targeted an 8% nominal GDP growth rate, the same two things would happen.

So, I can read Kocherlakota as making sense by interpreting him as calling for the Fed to change its operating procedures, something that he does not directly do in his statement.

The thing to remember is that the Fed has conditioned most people and most macro economists to believe that the setting of the Fed funds rate IS monetary policy. Thus, if the funds rate were zero, then monetary policy could not really be any looser. From that viewpoint, Kocherlakota's statement is, to say the least, counter-intuitive. Raising interest rates is by definition a tightening of policy.

But things don't have to be this way.

Raising an inflation target would be by definition a loosening of policy and would cause interest rates to rise.

People, the theoretical and intellectual foundations for having monetary policy be a Fed funds target set by some kind of secret type of Taylor rule are weak in general and super weak in our present circumstance.

I still strongly reject the plausibility of the "lets raise inflation to lower the real interest rate" meme that sometimes floats around (yes I'm talkin' to you LeBron), but could totally get on board the "let's target an inflation rate of 4-5% to avoid deflation" train.