Relax: the Fed isn't about to catch fire or melt. This isn't about that sort of warming. It's about a different, more benign sort of Fed warming that my pals at the Mercatus Center claim to have discerned. Still, I don't believe them. Call me a Fed warming skeptic if you like, but so far as I'm concerned, it's all fake news.
Since Jay Powell announced the Fed's new average inflation targeting (AIT) strategy last week, both Scott Sumner and David Beckworth have welcomed it as a step, albeit only a tenuous one, toward their own (and my) preferred policy of NGDP level targeting. Scott calls "average inflation targeting…a tiny step forward," though one that will allow the Fed more discretion than a move to price-level targeting would. David likewise observes that, although it isn't quite an NGDP level target, AIT "is a step in that direction."
Scott and David also seem to agree that a move to strict price level targeting (PLT) would take the Fed still closer to an NGDPLT ideal. Were they to play "Hot and Cold" with Jay Powell, with the intent of steering Fed policy toward NGDPLT, they'd shout "getting warmer!" any time he moved Fed policy further away from strict inflation targeting (SIT), with its "bygones are bygones" response to inflation over- and undershooting, and closer to price level targeting (PLT), as he did last week.
I only wish I could join that chorus! Alas, I can't, because I don't think it's correct to say that a move from SIT to AIT (and hence toward PLT) is also a step toward NGDPLT. It could turn out that way. But it could also turn out to be a step the other way, or one that leaves the Fed neither warmer nor cooler than it was before. So while I agree with Scott that the Fed has granted itself more scope for discretion, I'm not convinced that its new policy has a bright side.
Supply and Demand
Regular Alt-M readers know that I agree with Scott and David 99 and 99/100ths percent of the time. So why not now? Unless I'm mistaken, in arguing as they do Scott and David are implicitly downplaying supply shocks; that is, they're assuming that any price-level changes the Fed encounters reflect disturbances to aggregate demand. When that's so, PLT and NGDPLT are equivalent, and it logically follows that any change that takes the Fed closer to PLT also takes it closer to NGDPLT.
But if demand shocks were really all that mattered, there wouldn't be any reason to recommend NGDPLT targeting at all. Instead, Scott and David and other Market Monetarists could spare themselves a lot of effort by simply pleading for price-level targeting. Again: if supply shocks aren't important, NGDPLT and PLT are practically one and the same. And of the two, PLT is far easier to market as a special case of inflation targeting.
But supply shocks do matter! And now is no time to be arguing as if they didn't. As I type this, the U.S. economy is reeling from what may well turn out to be the mother of all adverse supply shocks! That makes the case for preferring NGDPLT to PLT as strong as ever. It's also why a step away from SIT and toward PLT can't really be said to be a step toward NGDPLT.
Just how do NGDPLT and PLT differ in practice when supply shocks occur? Consider the lockdown supply shock, but suppose for argument's sake that it didn't involve a concurrent shock to aggregate spending: people keep spending on stuff; but because fewer are working, less stuff is being produced. Under PLT, the Fed would either have to keep the price level from rising at all in response to reduced real output, or it would have to act quickly to restore an increased price level to its original path. Either policy would require a reduction in NGDP. In contrast, NGDPLT would simply let prices rise. In the case of a positive supply shock, NGDPLT would let the price level decline, while PLT would call for offsetting monetary expansion.
Clearly, a world in which supply shocks matter is no longer a world in which PLT and NGDPLT amount to the same thing. Instead, as I pointed out in my last post, when it comes to supply shocks, NGDPLT resembles strict inflation targeting (SIT), with its bygones are bygones attitude toward unanticipated price level movements. In a "supply shocks only" world, a step from SIT and toward PLT is a step away from NGDPLT.
Of course, in the real world, central banks have to deal with both supply and demand shocks. For that reason, the Fed's move from SIT to AIT and hence toward PLT isn't obviously a move away from NGDPLT. But neither is it obviously a move toward it. Whether it turns out to be one or the other or neither will depend on the shocks the Fed confronts. And the one thing about shocks that we know for certain is that we don't know which ones are in store.
An Asymmetric Target
Many critics of the Fed's move to average inflation targeting observe that the new policy commitment lacks credibility. In particular, they note that, should the Fed ever find it has exceeded its long-run inflation target, it may be unwilling to expose the economy to below-target inflation—and correspondingly lower employment—for the sake of making up for its mistake.
It's a perfectly plausible argument—so much so that I've made it myself! But during his recent Macro Musings interview with me, David Beckworth argued that it also reinforces the argument that the Fed's new strategy will take it closer to NGDPLT.
In making this particular argument, David doesn't ignore supply shocks. On the contrary: his argument is strongest for the case of an adverse supply shock, for if the Fed is likely to allow upward price shock bygones to be bygones, its response to such a shock will indeed resemble that of an NGDP level-targeting central bank.
So far, so good. But the hitch this time is that a Fed that lacks the fortitude needed to compensate for inflation overshooting from adverse supply shocks is no less likely to lack the fortitude needed to make up for inflation overshooting that results from adverse demand shocks. In the latter case, "asymmetric" AIT would be less like NGDPLT than symmetric AIT. In short, we once again have a policy innovation—not making up for above-target inflation only—that could take the Fed further away from, rather than closer to, an NGDPLT ideal, depending on the sorts of shocks the Fed ends up facing.
So, my fellow Market Monetarists, let's not be breaking out the cigars and champagne and confetti just yet! Things could indeed get better, NGDPLT-wise. Or not. It's just too early to tell. We must wait and see. In the meantime, instead of telling the Fed that it's getting warmer, I suggest we keep putting the heat on it.