Other than the occasional call for Canada to adopt the US dollar, discussion of Canadian monetary policy mainly consists of the C. D. Howe Institute and the Bank of Canada praising inflation targeting. As Thomas Palley reminds us, another perspective exists:
A few months ago the Federal Reserve seemed to be inexorably moving toward adopting an inflation targeting policy regime. Fed Chairman Ben Bernanke is known to support such a framework having co-authored several articles and books on the subject. Moreover, his institutional hand had been strengthened by Frederic Mishkin’s appointment as Vice-Chairman of the Fed, Mishkin being one of Bernanke’s co-authors.
This situation has been transformed by Congressman Barney Frank’s assumption of the Chairmanship of the House Financial Services Committee. That is because Frank is known to be an inflation targeting skeptic, and his Chairmanship sets the stage for an important policy debate that also pertains to policy in Europe, Canada, and developing economies.
The economics profession is widely identified with supporting inflation targeting. However, the profession is also unusually monolithic, which makes it important that alternative positions get heard.
Former Federal Reserve Chairman Alan Greenspan long opposed inflation targeting on “process” grounds. Though known as an opponent of inflation, Greenspan’s view was that an explicit inflation target would be a millstone around the Fed’s neck. In particular, it would limit flexibility and discretion to adjust policy in response to unexpected circumstance. Additionally, inflation targeting could promote damaging mechanical policymaking, as happened with money supply targeting in the late 1970s. Lastly, it could provide an anvil on which financial markets could hammer and corner policy.
Greenspan’s opposition reflects his policymaker acumen. But there is a deeper case against inflation targeting that rests on economic theory and differences in the way the economy is understood.
Today’s economic consensus is rooted in Milton Friedman’s notion of a natural rate of unemployment that harkens back to classical economics, which ruled thinking in the Great Depression era. According to this classical view inflation and monetary policy have no lasting impacts on the unemployment rate or real wages, which are determined by labor supply and demand conditions that are independent of inflation. Moreover, inflation cannot affect economic growth, which is determined by labor force growth and the rate of technological advance that are again independent of inflation.
These propositions represent today’s consensus. But there is another view that holds there is a trade-off between inflation and unemployment. Slightly higher inflation can reduce unemployment because it greases the wheels of adjustment in labor markets. It is hard to lower wages because of trust and conflict issues. Consequently, instead of lowering wages in depressed sectors it is more efficient to raise wages and prices in the rest of the economy, thereby accomplishing the relative price adjustments needed to restore full employment.
Lower unemployment can in turn raise real wages because it gives workers more job options and increases their bargaining power. Finally, higher wages may raise growth by strengthening consumer demand conditions and stimulating investment – but this requires the economy to be “wage-led”. Alternatively, if the economy is “profit-led”, higher wages may lower growth by diminishing profitability and discouraging investment.
The important point is there are two competing coherent views of the economy, and they generate very different policy perspectives. According to the current consensus, monetary policy only affects inflation, which encourages very low inflation as the Fed’s goal. However, the minority post Keynesian view sees monetary policy as having lasting impacts on inflation, unemployment, real wages, and maybe growth. That makes inflation one concern among many.
This difference means that inflation targeting is an undesirable frame for public policy. Inflation is a “bad” in the sense that we would all prefer high employment without inflation. Consequently, if monetary policy is presented purely in terms of an inflation target, there will be a tendency to choose a low target. If the choice is presented as two versus three percent inflation, two percent is likely to win out and policy will also tend to privilege addressing inflation risks over employment risks.
However, if the reality is monetary policy impacts a quadruple consisting of inflation, unemployment, real wages, and growth, two percent inflation may be inferior to three percent inflation accompanied by higher real wages, lower unemployment, and possibly faster growth. That is the economic logic behind skepticism about inflation targeting as a policy framework.
Copyright Thomas I. Palley