A couple of days ago I noted that Josh Barro had a good understanding of US monetary policy and the causes of the Great Recession. In my post I wondered whether Josh also would favour NGDP level targeting.
He is Josh’s “answer”:
I would prefer to see the Federal Reserve adopt a rule, such as NGDP level targeting, that would lay out an orderly path for monetary easing in recessions and tightening upon recovery. But I don’t think we need to worry about the Federal Reserve losing its grip on any ad-hoc decisions to allow some moderate inflation. It’s just not in this Fed’s nature—and the markets know it.
The quote above is from an article today in on the Forbes website where he discusses Amity Shlaes’ very odd claim that Milton Friedman would have been against QE in the US over the last couple of years. I don’t want to go into that discussion (I will simply become too upset…). Let me instead quote Josh:
The Cleveland Fed inflation estimates, based on financial market data including the interest rate spread between ordinary and inflation-protected Treasury bonds, show expected inflation of 1.4 percent per year over the next ten years. So, if Shlaes knows about an inflation bomb that the young guns on Wall Street can’t see, she has the opportunity to go make a ton of money in the bond markets.
Inflation isn’t nearly as mysterious as Shlaes makes it out to be. Milton Friedman is on point here: “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” If inflation starts to get out of control, all the Fed has to do is contract the money supply.
The Fed is sure to have to do this in the medium term. The housing crash, banking crisis and recession caused a sharp drop in the velocity of money. MV = PQ, so the Fed had to greatly expand the monetary base in order to prevent deflation. As the velocity of money picks up, the Fed will need to contract the monetary base to prevent rapid inflation.
If it’s this simple, why do countries ever have undesirably high inflation? Sometimes, as with Zimbabwe, it’s because they’re printing money as a fiscal strategy. At other times, as in the U.S. in the 1970s, there is insufficient political will for the sometimes-painful step of monetary contraction.
The former is not a serious fear in the United States. As for the latter, it is possible to imagine a central bank that lacks the discipline to tighten when appropriate. But not this Federal Reserve, which has a strong bias toward disinflation and many of whose members seem to have had to be dragged, kicking and screaming, into the insufficient amount of easing we have had to date.
Josh is obviously completely right and I hope that he in the future will continue to participate in the debate concerning US monetary policy and continue to advocate NGDP level targeting.
PS David Glasner also has a comment on Amity Shlaes’ claims concerning QE and Milton Friedman – HEALTH WARNING! My friend David is moderately critical of Friedman in his comment – despite of this we are still friends;-)
UPDATE: Scott Sumner also has a comment on Josh Barro.