How Does Paul Ryan Want to Target Inflation?

He would have to use Quantitative Easing anyways

While my previous post talked about the variety of ways Paul Ryan should prefer an NGDP target over an inflation target, I realized that a lot of the Fed's policies that Paul opposes would still be necessary in a world of inflation targeting. In his 2010 Op-Ed with John Taylor, he called the quantitative easing programs  "departures from rules-based monetary policy" that have "increased economic instability and endangered the central bank's independence." But would strict inflation targeting really solve the problem?

Below I've created a graph plotting quarterly annualized headline CPI inflation which includes commodity prices, the 2% inflation target, along with zones indicating when the two quantitative easing programs were hinted at and then executed. The dates for the QE announcements were taken from a conference paper, and they are used to show how policy and inflation were related.


As you can see, for much of the past four years, headline inflation was significantly below the 2% target traditionally set for the Fed. In response, the Fed hinted at the quantitative easing programs and drove up inflation. Yet Paul Ryan opposes these policy interventions. The question that I pose to Paul Ryan and his supporters is "what would you have had the Fed do during those time periods?" The short term interest rate was already at zero, so what would Ryan have suggested to fulfill the mandate? Paul would have been forced into unconventional monetary policy such as QE or Operation Twist just to fulfill his proposed mandate!

Under these conditions, there's no reason for Paul Ryan to not opt for an NGDP target instead. If you're going to be using unconventional monetary policy tools, you might as well use them to target a metric that is critical for stable, robust growth. An NGDP regime would be simple, rule based, and verifiable. So when choosing a monetary policy regime, why not NGDP level targeting?

"Fed Up" With Paul Ryan

The following is an essay that I wrote for NextGen Journal, an intercollegiate journal focusing on the issues facing America's youth.
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I'm “Fed” up with Paul Ryan. No, I don't mean his regressive tax proposals, unrealistic budget projections, or his peculiar approach to health care. I am frustrated by something more serious: his call for monetary policy that would only put our economy in greater danger.

The Federal Reserve controls U.S. monetary policy by controlling the growth of the money supply in accordance with its dual mandates of “maximum employment” and “price stability.” Traditionally this has meant unemployment below 5% and inflation around 2%. According to Paul Ryan, recent Fed actions have caused massive inflation and have debased the dollar. Therefore, the Fed should abandon the “maximum employment” part of its mandate and focus on targeting headline inflation. However, a look at the data suggests this would be the wrong way to go.

Ever since July of 2008, annual inflation has been at about 1.1%, far below the 2% target traditionally set by the Fed. Long-run expectations of future inflation are also below target, at 1.26%. Moreover, the dollar is actually stronger now than it was at the beginning of 2008. The value of the dollar last peaked at the height of the financial crisis, showing that, in recent times, a strong dollar is not a sign that markets are doing well, but rather that they are breaking down.

So if inflation is low, and the dollar is strong, why has the Great Recession been so great? The biggest reason is that nominal gross domestic product (NGDP), a measure of the total dollar value of goods produced by the U.S. Economy, has collapsed. During the worst quarter of the crisis, NGDP fell at an annualized rate of 8.4% and has not returned to the previous trend, something unheard of for any other recession in the past century. The fall in NGDP has harmed the economy in many ways, most importantly by making it harder for families to meet mortgage payments and for business to justify further expansion.

To change this, the Federal Reserve should announce a policy of restoring NGDP to its pre-crisis 5% trend, and take all necessary steps to reach the goal. This policy enjoys a wide range of support from conservative and liberal economists alike. Changing the Fed's mandate to targeting the level of NGDP would change market expectations and work to stimulate growth now.

Representative Ryan might argue that this shift would be just another form of discretionary monetary policy that jeopardizes the stability of the economy. In his 2010 op-ed with John Taylor, Ryan demanded that the new monetary regime have “greater simplicity; a description of interest-rate responses to economic developments including how the Fed will achieve those responses through money growth; and greater attention to commodity prices, including food and energy, as opposed to a myopic overemphasis on core inflation.” Fortunately, NGDP targeting addresses the root of those concerns just as well, if not better, than Ryan's version of inflation targeting.

First, unlike the current vague balance between “maximum employment” and “price stability”, an NGDP mandate only targets NGDP, making it a simple rule based regime. On the other hand, inflation is not so simple. To properly measure it, you need to pick which prices to check, and then adjust for quality increases. If a car's quality and price both improve, how do you know the real value? Moreover, which inflation – CPI, PCE, or PPI – should the Fed target? This confusion only complicates matters and increases policy uncertainty.

Second, a simple mandate translates into self-evident money supply responses to economic conditions. If NGDP growth is above the 5% trend, the money supply should contract. If NGDP growth is, as in the current situation, below the 5% trend, the money supply should expand. I choose not to talk about interest rates because, as Milton Friedman once wrote, they are misleading guides to monetary policy. Low interest rates can be the result of easy money that pushes down the market interest rate, or the result of tight money that leaves nobody wanting to borrow.

Third, an NGDP target shifts away from a myopic focus on core inflation and can effectively deal with asset bubbles. Even if focusing on core inflation led the Fed to hold interest rates “too low for too long” during the housing bubble, the inclusion of commodity prices in inflation indicies doesn't solve the issue. During the 90's and the early 2000's, the computer revolution increased productivity growth, driving down all measures of inflation, including those that took commodity prices into account. In response, the Fed eased monetary conditions and lowered interest rates to hit its inflation target. On the other hand, NGDP targeting would have actually tightened money in response to the 7% NGDP growth, thus popping the bubble before it grew large enough to hurt the broader economy.

Yet in spite of all this, Ryan wants to limit the mandate of the Fed to only inflation. On one issue, I agree with Paul Ryan, “we are on an unsustainable path” and “it doesn't have to be this way.” But to embark on a new path, we need an NGDP target, not inflation mongering. The first is an enlightened path forward, the second is but a dangerous step back that compounds our economic stagnation.