Should the Fed target inflation instead of unemployment? Can it?

Cardiff Garcia has a post at the FT that argues that as the unemployment rate comes down closer to the Fed’s target of the natural rate, it should place more emphasis on it’s inflation target which it continues to miss on the low side.

This begs the question of whether or not the Fed can increase inflation in a recession when aggregate demand is low and the economy is operating well under capacity. Inflation may be “always and everywhere a monetary phenomenon” but that really just says that an increase in the money supply is a necessary condition for inflation, not that it is a sufficient condition.

I tell my students that two things are necessary for inflation: an increase in the money supply and demand to use that money to chase fewer goods. That is, if the money is sitting in a checking account (or a reserve account) and is not entering the economy, then we will not get inflation.

This is why I remain skeptical about NGDP targeting. It makes sense in the abstract to target something like 5% NGDP growth and so any lack of real GDP growth gets picked up by higher inflation. But where is the inflation coming from? If there is a lack of demand, I don’t see how the Fed can induce 7% inflation if the real economy contracts by 2%.

That said, the one country that seemed to pull it off recently was Israel. And Stanley Fischer, who has recently been appointed (but not, I believe, yet confirmed) to be the number two at the Fed, was the head of the Bank of Israel. Perhaps he can explain how it was done.


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