Tuesday, November 1, 2011

NGDP Targeting, the "Volcker Moment", and Chuck Norris

Free Exchange points out that the tight-money policy of Paul Volcker in the early 1980s:
did not succeed by changing people’s expectations of inflation. It succeeded by crushing demand. As unemployment moved up the Phillips Curve, inflation plummeted. Only then did inflation expectations stabilize at a lower level.... The lesson of the Volcker disinflation is that changing expectations depends crucially on delivering on the target. Naming an inflation or money supply target is helpful, but insufficient unless the central bank demonstrates it is willing and able to achieve it. 
That statement reminded me of this post from Worthwhile Canadian Initiative:
Thesis. We teach the monetary policy transmission mechanism like this: the central bank pulls a lever, and that lever pulls other levers, which eventually move the target variable in the direction the central bank wants to move.
Antithesis. That's wrong. A credible central bank is exactly like Chuck Norris. It looks at the thing it wants to move, and the thing moves, and all the other levers fall into place where they should be. Causation runs backwards from the target variable. Credible central banks don't actually do anything. They just threaten to do things. But a credible central bank never needs to carry out its threats.
Synthesis. That's not quite right either.
1. Even Chuck Norris can't make the impossible happen. A credible central bank can move the economy just by saying that it wants the economy to move. But it must be a new equilibrium that it moves to. And maybe that new equilibrium won't be an equilibrium unless the central bank moves its lever. Chuck Norris can't clear the room if he is standing in the only doorway. He has to step aside to let people exit, even if he doesn't need to throw anyone out.
2. Chuck Norris wasn't always Chuck Norris. He had to earn his reputation. In the early days, or in unfamiliar territory, he actually had to carry out his threats. Till people learned the new regime.
Basically, in order for Chuck Norris to impact behavior, people have to think he'll kick their ass. The central bank (Fed) has to convince people that it's going to do what it says it intends to do when circumstances dictate. In other words, every now and then, Ben has to kick some ass. If you want higher NGDP, you can't make it happen by standing in the room looking tough. You have to actually break a few skulls.