Matt Rognlie: Goals of Monetary Policy
MR:
Is there any reason to target headline inflation? : Jim Bullard, President of the St. Louis Fed... his speech falters on a foundational issue that he barely even addresses: why should the headline CPI be a goal at all? He takes for granted that headline CPI should be the medium-term target of monetary policy, and that targeting the core is just a (flawed) short-term approach for achieving it.... Admittedly, targeting the headline CPI may be the traditional goal of monetary policy. But it’s not clear why that tradition is valid, or whether there is any cogent rationale for caring about this particular price index.... Let’s think about why we might want to stabilize inflation in the first place... the direct cost of inflation... [i] inflation widens the gap between the yield on bonds (the nominal interest rate) and the yield on money (usually zero), leading consumers to hold an inefficiently low amount of money... the practical relevance of the Friedman Rule is surely minimal.... [ii] In most New Keynesian models, the cost of inflation arises from price stickiness.... But of course, the reason that food and energy prices were excluded from the core CPI in the first place is that they are not sticky—in fact, they change all the time, and they’re extremely volatile. If you’re concerned about price dispersion, you absolutely do not want to target the full headline CPI. [iii]Interaction with capital gains taxes. This may be the most serious cost of inflation.... In short, looking at the direct costs of inflation, I see little to support Bullard’s contention that headline CPI should be our target of choice.
Next there’s the fact that stabilizing inflation is a way to achieve macroeconomic stabilization in general. But as I discussed in a previous post, there is no reason why any form of the CPI should be appropriate for this.... It’s very hard for me to see how food and energy prices provided much useful information to the Fed in late 2008 and early 2009—it was easy enough to see equity prices and inflation expectations collapsing. In fact, during the first half of 2008, increases in energy prices arguably misled the Fed into holding back on interest rate cuts when it should have been more aggressive. The decision to keep the federal funds rate at 2% until October was in retrospect a very, very serious mistake, and headline inflation was one of the culprits.
Finally, one of the most commonly cited reasons for stabilizing inflation is the importance of nominal contracts... you want the meaning of “one dollar” to be predictable over time.... But how should we stabilize the meaning of a dollar—with respect to wages or consumption? As I’ve discussed before, there isn’t any answer that’s obvious from first principles... in the real world... you really, really want to be able to pay your debts, and your ability to pay those debts is closely related to your nominal income.... If an oil shock comes along and raises the cost of consumption by 3%—while barely increasing wages at all—it isn’t prudent to try and push all other prices (and therefore wages) 3% below trend to make up the difference.
All in all, I can’t see why Bullard is so confident that the headline CPI is more important than the core.... [Core] is still an improvement, and it wouldn’t have kicked us off track in the catastrophic summer of 2008.
