Cochrane: "Woodford Needs to Fight Harder!"

When reading John Cochrane's critique of Woodford's call for NGDP targeting, I felt it was actually a great justification for why Woodford needed to write that paper, and for why the market monetarist project is something that we need to continue to fight for.

Cochrane's largest argument rests on a credibility argument -- that there's no way for the Federal Reserve to credibly commit to a permanent expansion of the monetary base, because the market expects that the Fed will tighten to reach 2% inflation in the future. As a result, because there's no way to effectively change expectations of the future monetary base, there's no way to change the level of present NGDP.  In the words of Cochrane:

How can the Fed promise today to do something it will very much regret tomorrow, and get people to believe that promise?  More deeply, how does the Fed commit to allowing "just a bit" of inflation in the future, and not starting down the path of the 1970s again?

Cochrane must know that hose are two very different questions! When we call for a 5% NGDP target, we're not calling for the path of the 1970's -- to say so is a complete straw man. Thus, the real question is how do we convince people that the Fed won't tighten in response to mild inflation. And to me, the answer is simple: declare that the Fed is targeting NGDP.

Why? Because all of the current analysis on credibility and promises implicitly assumes that the Fed is targeting inflation! Of course, an inflation targeting Fed's promise to hold rates low until an NGDP target is hit is not credible because everybody knows the Fed will tighten in response to the higher level of inflation. If, on the other hand, if people know that the Fed is willing to tolerate higher levels of inflation because it is in their mandate, the credibility problem will go away.

The problem is that everybody is looking at the standard loss function for inflation and arguing that NGDP targeting doesn't minimize the function. If you're just trying to minimize the squared deviations from 2% inflation, of course an NGDP target is nonsensical; an NGDP target actively encourages deviations from 2% inflation to correct for past mistakes. However, if the loss function is seen as the squared deviation of actual NGDP from trend NGDP, then the promise to target NGDP is much more logical.

Formally, if the Fed's optimal policy is described by minimizing this:

(π - 2)²

Of course the Fed won't manage to minimize this:

(Y-Ytrend)²

This is why Woodford's paper is so important. It's the first step towards convincing economists and market participants that the Fed's loss function is changing. Given that Woodford presented the paper at Jackson Hole, the premier meeting on monetary policy, the paper is a key step in signalling that NGDP targeting is gaining legitimacy.  If successful, people will realize that the Fed's new policy will tolerate a temporary inflation increase in order to bring NGDP back to trend. No longer does the Fed have to "credibly promise to be irresponsible", it can just change the definition of responsibility. 

So when Cochrane argues that NGDP targeting is flawed because the Fed can just go back to inflation targeting, what he's actually saying is that academics should fight extremely hard to legitimize NGDP targeting. When a monetary policy that targets NGDP becomes as self-evident as one that targets inflation, it will be no difficulty to credibly commit to a new monetary regime.