Academic journal article Review - Federal Reserve Bank of St. Louis

Inflation Control: Do Central Bankers Have It Right?

Academic journal article Review - Federal Reserve Bank of St. Louis

Inflation Control: Do Central Bankers Have It Right?

Article excerpt

(ProQuest: ... denotes formulae omitted.)

According to conventional wisdom, central banks should control inflation by increasing the central bank's nominal interest rate target when inflation is above target and by decreasing the nominal interest rate when inflation is too low. But neo-Fisherites argue that the reverse is true. For example, a central bank that sees chronically low inflation has no choice but to increase its nominal interest rate target, which will cause inflation to go up, according to neo-Fisherian doctrine.

The purpose of this article is to explore the properties of two standard macroeconomic monetary models-a New Keynesian (NK) model and a segmented markets model-and show how these conventional models exhibit neo-Fisherian properties. Thus, neo-Fisherism is not about some outlandish, radical new macroeconomic theory. In fact, conventional wisdom is somewhat hard to come by in what are considered conventional macroeconomic models, in that the conventional results (lower inflation resulting from a higher nominal interest rate target) require some specific, and perhaps extreme, assumptions.

It might seem surprising now, but before the 1980s many prominent economists did not subscribe to the view that the job of controlling inflation resides solely with the central bank. Indeed, at a time of relatively high inflation in the United States in 1980, James Tobin (1980), an influential macroeconomist at Yale University, argued that "it is not possible to do the job Williamson [disinflation] without effective wage and price controls of some kind...there could be worse prospects, and probably they include determined but unassisted monetary disinflation."

At the time, it was widely recognized that inflation was too high and that there would be economic benefits from reducing the inflation rate. Tobin argued that monetary disinflation-a reduction in inflation to appropriate levels engineered solely by the central bank-would be far too costly; disinflation would require a period of above-normal unemployment lasting more than 10 years. These economic costs of disinflation could, and should, be mitigated through wage and price controls, according to Tobin.

Of course, policymakers in the United States did not follow Tobin's advice, and his dire predictions did not come to pass. During Paul Volcker's term as Federal Reserve Chair, an unassisted monetary disinflation in fact occurred, with the inflation rate (consumer price index inflation) falling from a peak of 14.4 percent in May 1980 to 3.6 percent in 1985. The 1981-82 recession, often attributed to the monetary disinflation, was severe but short, particularly relative to what Tobin had imagined.

Volcker's disinflationary experiment was compelling, and this pushed monetarist ideas into the forefront at central banks. The most prominent proponent of monetarism (sometimes known as the quantity theory of money) was Milton Friedman. Friedman (1968) argued that an optimal monetary policy would involve targeting the growth rate in some measure of the money supply. Such a policy, according to Friedman, would make the inflation rate stable and predictable, and it would minimize the contribution of monetary disturbances to business cycles. Roughly, Volcker's disinflation was carried out following Friedman's prescription- Volcker dramatically reduced the rate of money growth, and inflation came down.

But the move by many central banks to follow money growth targeting as a permanent policy did not meet with success, principally because of the unstable relationship between money and other macroeconomic variables that became even more unstable in the 1980s. In response to this environment, monetary policymakers in many countries, including the United States, adopted the following principles: (i) Inflation control should be the purview of the central bank-the surviving element of monetarism in modern monetary policy, and (ii) monetary policy should be implemented through the targeting of a short-term nominal interest rate, typically an overnight rate. …

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