A Rebellion at the Federal Reserve?

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Chicago Fed President Charles Evans suggests a major break from the central bank's orthodoxy.
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[Reuters]


Chicago Federal Reserve president Charles Evans doesn't look the part of a heretic. But in the cozy, conservative club that is central banking, he certainly qualifies. While most of his colleagues at the Fed have recently taken an even more hawkish turn, Evans remains a champion of additional monetary stimulus. And on Tuesday he took an even bigger step: He became the first sitting Fed member to endorse nominal GDP (NGDPlevel targeting

Sounds wonky? It is. But here's why Evans' suggestion is also extremely bold. The Fed famously has a dual mandate: It's supposed to promote the maximum level of employment consistent with its two-percent inflation target. In reality, this dual mandate often looks more like a single inflation mandate. NGDP level targeting would do away with this problem by rolling the mandates together. And right now, that would mean a much more aggressive Federal Reserve.

The debate over NGDP level targeting and inflation targeting is part of a larger war that's been going on the past few years in the normally staid world of central banking. It's a three-sided debate over what the Fed should do now. There are those who think the Fed's dual mandate goes too far in promoting full employment, those who think it's just about right, and those who think it doesn't go far enough. 

In the end, this is really a clash over inflation. After all, we're talking about central bankers here. The first group is worried that by effectively printing more money to goose the economy (better known to in policy circles as "quantitative easing"), the Fed has already created future inflation. The second group isn't worried about the money that's already been printed, but believes that running the presses any further will create future inflation. Finally, a third group is worried that if the Fed doesn't print more money, there won't be enough inflation to keep the economy healthy. Evans belongs to the last camp.

Actually, it's not quite true that Evans wants more inflation. He wants more income. To revert to econospeak, he wants the total size of the economy -- that is, inflation plus growth, or nominal GDP -- to get back to the long-term trend it was on before the financial crisis and recession. He would prefer if NGDP goes up due to real growth. But if it's a choice between stagnating NGDP and NGDP that's going up mostly because of inflation, Evans would choose the latter.

STOP WORRYING AND LEARN TO LOVE INFLATION 

Why is steadily rising NGDP so important? It's about debt. Most contracts assume that NGDP will rise about five-percent a year. If NGDP (and incomes) doesn't go up that quickly, it becomes harder and harder for people to pay back their debts. That's what made the Great Recession so great. NGDP growth actually went negative for the first time in half a century. What started as a subprime problem became a widespread debt problem because people's incomes didn't increase like they expected.

But central banks don't usually speak the language of NGDP. They speak the language of inflation. It's not because inflation is a better signpost for policymakers than is NGDP. It's not. None other than Ben Bernanke said so in 2003, when he argued that both NGDP and inflation are the best indicators for central bankers. It's more that people are more familiar with inflation. Besides, NGDP and inflation almost always give central bankers the same policy signal. Except for times like now.

Inflation is right around the Fed's two-percent target. But NGDP is far, far below its long-term trend. What should the Fed do? So far, its answer has been: nothing. Evans disagrees. Up until Tuesday, he's framed his opposition in terms of inflation-targeting. His eponymous rule of thumb has been that the Fed should commit to keeping interest rates at zero as long as unemployment is above seven-percent or inflation is below three-percent. It's a hybrid step between the Fed's current inflation-targeting regime and an NGDP level target. The idea is that the Fed should be more flexible about its inflation target when the economy is stuck in a deep hole, so we can dig ourselves out of it.

LESSONS FROM THE DEPRESSION 

That brings us to the potential danger of the Fed's current policy. It might strangle the U.S. recovery. Strict-ish inflation targets -- like the kind Bernanke & Co. are now pursuing (even if they say they're not) -- only work when the economy is working. As long as slumps aren't too big, everything is fine. But if the economy is depressed, a too-low inflation target acts like a speed limit on recovery. Consider the Great Depression. Here's what happened to inflation after the economy bottomed out in FDR's first year in office.

GDInflation.png

By early 1934, inflation was running at over five-percent a year. But unemployment was still only slowly coming down from its peak of 25 percent. An inflation-targeting central bank might look at this picture and surmise that it was time to raise rates -- even if it had a dual mandate like the Fed. That would be madness. Unfortunately, this isn't some strawman. It's precisely what Richmond Fed president Jeffrey Lacker said the Fed might have to do in the next few years: hike interest rates despite still too-high unemployment. Lacker is an outlier on the FOMC, but the committee's most recent minutes showed a bias towards increased hawkishness. Such a scenario is sadly plausible.

That's not to say that inflation targets can't work. They can. They just have to be flexible enough. As previously mentioned, the so-called Evans Rule tries to imagine what a more flexible target would look like. But there's still a problem. Even a more flexible rule still puts a speed limit on recovery. It's just a higher speed limit. An NGDP level target, by contrast, is a speed minimum. It says that the Fed should make up for any past mistakes. If the Fed undershoots NGDP one year, it should try to catchup the next. It's a better target.

A PARADIGM SHIFT?

The Fed is still a long way off, if ever, from adopting an NGDP level target. But Evans' endorsement of the idea is a big first step in what could be a hugely important paradigm shift. Even if there isn't a large difference between the quasi-NGDP level target that is the Evans Rule and an actual NGDP level target, it's a fairly radical new way of framing policy. Rather than the central bank letting the economy recover faster, it puts the onus for a faster recovery on the central bank. 

Most incredible is how quickly the idea is gaining acceptance. It's true that writers like The Atlantic's own Clive Crook have long advocated the merits of NGDP targeting. But as recently as 2009, it was mostly just a few lonely bloggers like Scott Sumner and David Beckworth who picked up the torch. Then Goldman Sachs chief economist Jan Hatzius and Paul Krugman said they were willing to give it a try. Now, a sitting Fed president is on board. 

At this rate, it might not be long until we describe Evans as an orthodox central banker. Now that would be progress.
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Matthew O'Brien

Matthew O'Brien is a former senior associate editor at The Atlantic.

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