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Can the Fed commit?

September 5, 2012

Time consistency is the idea that what your preferences are now are not necessarily your preferences tomorrow. Today, you want to workout and eat vegitables tomorrow, but when tomorrow comes, you want TV and doughnuts. Recently, several prominent economists have called into question the wisdom of advocating higher NGDP growth now, because even if the Fed achieved it, they would just lower NGDP growth later. It is true that the current Fed cannot credibly constrain the future Fed and Congress can’t constrain future Congress.

There are two issues to address:
1. Whether or not to stabilize NGDP going forward.
2. Whether or not to engage in catch up growth because of the 2008-2009 period of low NGDP growth.

1. Stabilization has no time consistency problems. The Fed either hits it, or not, and politicians are either happy with them or not, both depending on if the target itself is politically stable. If the Fed board were fired for their misbehavior, how much incentive, exactly, would the next Fed board have to cause deflation? The incentives should be clear and consistent: miss the target and you’re fired.

If you assume that the Fed chairman acts purely on his own whim, and there are no constraints to his behavior, then the time consistency argument can be used to justify literally any misbehavior. Suppose the Fed has a year of 10% inflation. Because of time consistency, the Fed can’t reduce inflation to 2% next year, or they’ll have 18% inflation two years from now. The Fed has willfully and clearly violated their dual mandate. If there are no punishments handed out now, then perhaps Cochrane is correct and the Fed will undo anything it does today.

2. Catch up is where the problem with time consistency lies. I believe that the Fed is engaging in memoryless NGDP targetting, perhaps because catch up is politically unpopular. Both Cochrane and Greer seem to assume that higher NGDP growth during the “catch up” period will be politically unpalatable. Perhaps they are right. If so, then yes, we are pretty much stuck in this lower trend. But I’m not so sure. I don’t think that politicians would be opposed to 7% nominal growth, especially if it meant lower unemployment. In the Austrian theory of the business cycle, it is exactly this political desire for overly high NGDP growth which gets the economy into trouble to begin with. But then we are back to arguing what the impact of higher nominal growth would be. And that’s an argument worth having.

Further reading:
Sumner comments.
Is promising hard?
Karl Smith on Cochrane
P.S.: If the best reason you can think of to “Why shouldn’t the government finance its spending by printing money?” is “It wouldn’t cause enough inflation”, something is wrong with your thought process.

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