Is dynamic inconsistency really the problem with inflation targeting?

Okay, I should really heed Brad Delong's two rules regarding Paul Krugman:
  1. Remember that Paul Krugman is right.
  2. If your analysis leads you to conclude that Paul Krugman is wrong, refer to rule #1.
But I've already stepped out of my field and way beyond where I have any business spouting off about what the Fed should do.  Maybe I'm just looking for someone to present a better argument for why inflation targeting is infeasible.

Besides, I'm actually pitting Krugman against Krugman, since what I know about inflation targeting I learned from reading the one and only PK

So the comments to my earlier post argue that dynamic inconsistency is the reason inflation targeting won't work.  I understand dynamic consistency, backward induction, and all that.  Or at least I hope I do, given I teach those fundamentals to each crop of 25 PhDs each year during their second semester of micro theory.

For context, here is Krugman's argument against inflation targeting, despite it being "the first-best solution" to our economic malaise:
But the key thing to recognize about this answer is that it’s all about expectations — the central bank only has traction over expected inflation to the extent that it can convince people that it will deliver that inflation after the liquidity trap is over. So to make this policy work you have to (i) convince current policymakers that it’s the right answer (ii) Make that argument persuasive enough that it will guide the actions of future policymakers (iii) Convince investors, consumers, and firms that you have in fact achieved (i) and (ii).
In reality, we haven’t even gotten anywhere near (i): the conventional wisdom is still that any rise in expected inflation above 2 percent is a bad thing, when it’s actually good.
The crux is really (ii), since Bernanke is convinced (inflation targeting has been his mantra forever) and markets will follow suit soon enough if the policy is made clear and the Fed follows the announcement with appropriate positions in the bond market.  Indeed, I believe this may even be the current de facto strategy of the Fed, but it's not the announced strategy, and I think that weakens its effectiveness. 

Anyhow, in the comments to my earlier post Workhorse writes:
It is optimal for a central bank to promise a future higher inflation. But after the recession is over (with higher expected inflation), it is no longer optimal to do so - the central bank (CB) happily goes back to be an inflation fighter. Markets rationally expect this and thus nobody believes the CB's promise (believe me, the markets are to some extent rational!).
I find this argument strange.  If the policy works then it seems the Fed will have plenty incentive to follow through with its inflation commitment so it will have the power to use the same tool in the next crisis.  Indeed, this is exactly the same incentive the keeps the Fed inflation fighting in the first place.

A popular guy, tightening does not make a Central Banker (Yoda speak).

Indeed, most worry about the Fed being too loose, hence their independence.

Finally, I think it is important to note, as Krugman does today, that modest inflation is no Road to Serfdom.  We talking a couple years at 3-5%, with a subsequent tightening announced well in advance.  Forward-looking commitments may even help to soften any recession such eventual tightening might induce.

Anyway, I really don't see how what's optimal for the Fed to commit to today won't be optimal for the Fed to follow through with tomorrow.  Unless, of course, events change.  And that wouldn't violate the commitment either, because changing policy in response to new information is not the same as reneging on a prior commitment under baseline expectations.

If inflation targeting is the first-best policy (and from what I've seen and read, I think it is) then that's what the most influential economists should be saying, loudly and often.

Mainly I'm just puzzled why the higher minds haven't been taking this stand.  My only guess is that Bernanke and Co are worried about diplomacy with China.  Hence Bernanke's double talk today about a "strong dollar" coupled with strong indications that he will keep the liquidity pedal the metal for a very, very long time.  Maybe Bernanke, being a government bureaucrat and all, needs to do the double talk.

Krugman doesn't.


  1. I thought the problem with inflation targeting was identified by Hayek in the 1920s. In the face of productivity increases, price stabilization leads to excessive money creation which bamboozles the intertemporal pricing mechanism, leading to too much resources being devoted to investment. As the lack of saving to underpin the over-investment is revealed, a recession follows.


Post a Comment

Popular posts from this blog

Nonlinear Temperature Effects Indicate Severe Damages to U.S. Crop Yields Under Climate Change

Commodity Prices and the Fed