Saturday, August 27, 2011

Krugman's reality problem

Paul writes that Rick Perry and inflation hawks on the FOMC are stopping Ben Bernanke from implementing a Fed policy that would be effective in increasing employment and growth.

He argues that for these reasons Bernanke is not acting on the advice he gave to Japan in 2000 about unorthodox policies to combat their situation which has parallels with ours.

Monetary economics superstar Michael Woodford makes a similar, though more nuanced, argument as well.

In both cases, the policy they want Bernanke to follow is to announce that the Fed will tolerate/encourage/create and sustain higher inflation than the Fed actually likes for some number of years in the future.

the only way for monetary policy to be effective in a liquidity trap was via expectations: the central bank had to convince the public that it would sustain monetary expansion even after the trap was over.

Yes, and if Grandma had wheels, she'd be a Harley.

People, the Fed has no commitment mechanism. For their policies to be credible, they must be time-consistent, meaning that they must be in the Fed's best interest AT THE TIME THEY HAPPEN (in each period).

The Fed simply cannot announce a time-inconsistent policy path and get the public to base their expectations on this non-credible announcement.

I am not a big Fed fan, but let's not excoriate them for failing to do the impossible.

1 comment:

James Oswald said...

Being in the group who would like to see a bit higher inflation, I am disheartened by this commentary. It implies that the reason inflation is too low is because higher inflation is politically constrained and that politicians would act to stop higher inflation and/or would be kicked out of office if they didn't. If this is the case, perhaps the best approach is for Congress to specify one precise target for the Fed to try to hit, just like the ECB or the New Zealand central bank. It has worked their without trouble of time consistency, so perhaps it could work here. I prefer level targeting and I think that might work. I fear for what could happen if the Perrys of the world cause substantial unexpected deflation.