Don't Crush The Economy Every Time Gas Gets More Expensive!

A blog about business and economics.
Dec. 13 2011 12:40 PM

Inflation Targeting Mishandles Supply Shocks

Paul Krugman takes a victory lap over UK monetary policy where, as he says, a number of voices were wrongly calling for tighter money in response to what were pretty clearly one-off shocks rather than an inflationary wage-price cycle. One moral of the story is that the inflation-panickers keep being wrong and we need to not listen to them. But Krugman's points here illustrate a deeper problem with the inflation targeting paradigm used by most central banks.

The issue is that economies are regularly buffeted by "real shocks." If terrorists blow up a bunch of oil pipelines, the price of gasoline is going to go up. If information technology lets retailers manage their inventory more effectively, the retail price of goods is going to go down. Neither of these events is properly undertood as "inflation" in a monetary sense, but they certainly show up in consumer price indexes. At the same time, these shocks have an impact on real output as well as on prices. If gas prices go up, cash-strapped households will delay purchasing durable goods and avoid indulgences (fancy dinners, vacations) reducing real incomes and output. Conversely, if retailers get more efficient at inventory management they'll hire more workers and stay open longer hours, raising incomes and boosting purchases throughout the economy. But inflation targeting seems to indicate that you should respond to positive supply shocks with looser money, and negative ones with tighter money. The most cartoonish version of this is practiced by the European Central Bank where they appear to genuinely believe that if more Chinese people go buy cars and this raises the price of oil, that the correct response is to increase unemployment in Europe. They even created a video game to try to instill this idea in young people.

Advertisement

The Fed and the Bank of England try to use the idea of "core" inflation to get around this. But even here lots of interpretive disputes can arise, hence Krugman's post. He and I agree that the Bank of England did the right thing, but they did it more or less by ignoring their statutory mandate. One completely politically toxic and unworkable way to do this would be to directly target wage inflation. A better view, however, is to see this as a reason to think Nominal GDP targeting is a better long-term strategy and not just a trick to cope with the current recession. NGDP targeting basically says that faced with a negative real shock you just suffer through a transitory increase in prices and then move on. Faced with a positive real shock, you let incomes rise but don't double-down and inflate bubbles.

Matthew Yglesias is the executive editor of Vox and author of The Rent Is Too Damn High.

TODAY IN SLATE

Politics

The Democrats’ War at Home

How can the president’s party defend itself from the president’s foreign policy blunders?

An Iranian Woman Was Sentenced to Death for Killing Her Alleged Rapist. Can Activists Save Her?

Piper Kerman on Why She Dressed Like a Hitchcock Heroine for Her Prison Sentencing

Windows 8 Was So Bad That Microsoft Will Skip Straight to Windows 10

Homeland Is Good Again! For Now.

Politics

Cringing. Ducking. Mumbling.

How GOP candidates react whenever someone brings up reproductive rights or gay marriage.

Building a Better Workplace

You Deserve a Pre-cation

The smartest job perk you’ve never heard of.

The U.S. Has a New Problem in Syria: The Moderate Rebels Feel Like We’ve Betrayed Them

The Ludicrous Claims Women Are Pitched at “Egg Freezing Parties”

Behold
Oct. 1 2014 11:48 AM An Up-Close Look at the U.S.–Mexico Border
  News & Politics
The World
Oct. 1 2014 12:20 PM Don’t Expect Hong Kong’s Protests to Spread to the Mainland
  Business
Moneybox
Oct. 1 2014 2:16 PM Wall Street Tackles Chat Services, Shies Away From Diversity Issues 
  Life
Outward
Oct. 1 2014 11:59 AM Ask a Homo: A Lesbian PDA FAQ
  Double X
The XX Factor
Oct. 1 2014 2:08 PM We Need to Talk: Terrible Name, Good Show
  Slate Plus
Political Gabfest
Oct. 1 2014 1:53 PM Slate Superfest East How to get your tickets before anyone else.
  Arts
Brow Beat
Oct. 1 2014 2:24 PM The New Interstellar Trailer Is the Most Exciting Yet
  Technology
Future Tense
Oct. 1 2014 2:26 PM The Apple Graveyard Leave a flower for a dead Apple product.
  Health & Science
Bad Astronomy
Oct. 1 2014 12:01 PM Rocky Snow
  Sports
Sports Nut
Sept. 30 2014 5:54 PM Goodbye, Tough Guy It’s time for Michigan to fire its toughness-obsessed coach, Brady Hoke.