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.