Inflation Targeting Mishandles Supply Shocks

Paul Krugman takes a victory lap over UK monetary policy where, as he says, a number of voices were wrongly calling for tighter money in response to what were pretty clearly one-off shocks rather than an inflationary wage-price cycle. One moral of the story is that the inflation-panickers keep being wrong and we need to not listen to them. But Krugman’s points here illustrate a deeper problem with the inflation targeting paradigm used by most central banks.

The issue is that economies are regularly buffeted by “real shocks.” If terrorists blow up a bunch of oil pipelines, the price of gasoline is going to go up. If information technology lets retailers manage their inventory more effectively, the retail price of goods is going to go down. Neither of these events is properly undertood as “inflation” in a monetary sense, but they certainly show up in consumer price indexes. At the same time, these shocks have an impact on real output as well as on prices. If gas prices go up, cash-strapped households will delay purchasing durable goods and avoid indulgences (fancy dinners, vacations) reducing real incomes and output. Conversely, if retailers get more efficient at inventory management they’ll hire more workers and stay open longer hours, raising incomes and boosting purchases throughout the economy. But inflation targeting seems to indicate that you should respond to positive supply shocks with looser money, and negative ones with tighter money. The most cartoonish version of this is practiced by the European Central Bank where they appear to genuinely believe that if more Chinese people go buy cars and this raises the price of oil, that the correct response is to increase unemployment in Europe. They even created a video game to try to instill this idea in young people.

The Fed and the Bank of England try to use the idea of “core” inflation to get around this. But even here lots of interpretive disputes can arise, hence Krugman’s post. He and I agree that the Bank of England did the right thing, but they did it more or less by ignoring their statutory mandate. One completely politically toxic and unworkable way to do this would be to directly target wage inflation. A better view, however, is to see this as a reason to think Nominal GDP targeting is a better long-term strategy and not just a trick to cope with the current recession. NGDP targeting basically says that faced with a negative real shock you just suffer through a transitory increase in prices and then move on. Faced with a positive real shock, you let incomes rise but don’t double-down and inflate bubbles.