3%?
One big question being debated right now is whether the "natural'' real rate of interest -- r* or "r-star" in econspeak -- has declined below 2%.
Over the long run , the Fed cannot control the real rate of interest -- that comes from how much people want to save and what opportunities there are for investment , i.e. the marginal product of capital. So , if the real rate of interest is now permanently lower , say 1% , then one might argue that the glide path should aim for 3% long-run interest rate -- 1% real plus 2% inflation target -- not 4%.
Janet Yellen recently came to Stanford and gave a very interesting speech that talked in part about a lower r-star , and seemed to be heading to something like this view. See the picture:
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| Source: Federal Reserve. |
(She also talked a lot about Taylor Rules , seeming to move much closer to John Taylor's view of how to implement monetary policy. See interesting coverage on Boskin Commission Report suggested the CPI is overstated by about 1% , as of 1996. Mark Bils , Do Higher Prices for New Goods Reflect Quality Growth or Inflation? argued that it's a good deal more. Mark measured that sales move quickly to new models , which they would not do if it were a price increase after controlling for quality. But Mark's analysis was limited to consumer durables , where quality has been increasing quickly. Many other CPI categories , especially services , are likely less affected. Philippe Aghion , Antonin Bergeaud , Timo Boppart , Pete Klenow and Huiyu Li's Missing Growth from Creative Destruction suggest there is another 0.5%-1% overall because of goods that just disappear from the CPI. (This post all started with discussion following Pete's presentation of the paper recently.)
This is good news. Nominal GDP growth = real GDP growth + inflation. Nominal GDP growth is relatively well measured. If inflation is 1% overstated , then real growth is 1% understated.
It also means our real interest rates are mismeasured. If 2% inflation is really 0% inflation , then 1% interest rates are really +1% real rates , not -1% real rates.
But back to monetary policy. Suppose that 2% inflation is really 0% inflation due to quality effects. Does that mean we should have a 2% long run inflation rate target?
I don't think so. Again , the motivation for a positive inflation target is that there is some economic damage to having to lower prices. But during quality improvements of new goods , nobody has to lower any prices. They are new goods! No existing good has to have lower prices. In fact , actual sticker prices rise.
There is a deeper point here. Not all inflations are equal. One purpose of the CPI is to compare living standards over time. For that purpose , quality adjustments are really important. Another purpose of the CPI is to determine if people have to undergo whatever the pain is associated with lowering prices. For that purpose , quality adjustments are irrelevant.
(On both prices and wages , we also should remember the huge churn. Lots of prices and wages go up , lots go down. The individual is not the average. Changing the average one or two percentage points doesn't change that many individual prices.)
In sum , the argument that quality improvements mean 2% inflation is really 0% inflation does not argue that therefore the inflation target should be 2% because otherwise people have to lower prices. They don't. Standard-of-living inflation is not the right measure for costs-of-price-stickiness inflation. In price stickiness logic , the Fed should be looking at a CPI measure with no quality adjustments at all! (At least in this simplistic analysis. This is an invitation to academic papers. If new and old goods are Dixit-Stiglitz substitutes , what are the costs of price stickiness with quality improvements?)
(Update: my correspondent points to "On Quality Bias and Inflation Targets" by Stephanie Schmitt Grohé and Martín Uribe.)
So the argument for a separate inflation target much above zero seems to be weak to me. We're back to Friedman rule vs. headroom , which argues for a direct nominal interest rate target. Since I'm not much of a fan of headroom , I lean to lower values.
Leaving aside price-stickiness , I'm still sympathetic to a price level target on expectations grounds. If the quality adjusted CPI is the same forever , then we have a CPI standard , the value of a dollar is always constant , and long-run uncertainty decreases. We don't shortern the meter 2% every year. For this purpose , we do want the quality-adjusted CPI , and for this purpose the inflation target is primary. An interest rate target would have to rise and fall with r*.
Real rate variation
r* is the real rate. There really is no reason that the "natural" real rate only varies slowly over time. Interest rates crashed in a month 2008 because real rates crashed -- everyone wanted save , and nobody wanted to invest. The Fed couldn't have kept rates at 6% if it wanted to.
So , the procedures used to measure r* , like those used to measure potential output , are a bit suspect. They amount to taking long moving averages , and assuming that "supply" shocks only act slowly over time. More deeply , typical optimal monetary policy discussions use a Taylor rule
funds rate = r* + 1.5 ( inflation - target) + 0.5 (output gap)
and recommend active short run deviations from the Taylor rule if there are "supply shocks" i.e. r* shocks. Just how the Fed is supposed to distinguish "supply" from "demand" shocks is less clear in reality than the models , which presume shocks are directly visible. A "secular stagnation" fan might say that the moving averages used to measure r* are instead picking up eternally deficient "demand ," like a driver with his foot on the brake complaining of headwinds.
Bottom line
As often in policy , we argue too much about the external causes and not enough about the logic tying causes to policy. r* may or may not have declined. But it does not follow that the glidepath nominal rate should be r* plus 2% inflation target. Maybe the glidepath should be 0% nominal rate or 4% nominal rate independent of r*. You see lots of mechanisms and tradeoffs worthy of modeling.