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Should we root for second best policies?

Summary:
The Fed is currently contemplating a set of monetary policy changes that might be viewed as “second best”. These include yield curve control and average inflation targeting. With yield curve control the central bank would peg the yield on longer-term Treasury bonds. This was Fed policy during the 1940s. Under average inflation targeting the central bank tries to make up for an inflation undershoot or overshoot, so that inflation will average 2% over the business cycle. In my view, these are second best policies.  Holding down long-term interest rates might be expansionary, but it also might end up being contractionary.  After all, contractionary monetary policy can easily decrease long-term interest rates by reducing expectations of inflation and economic growth.

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The Fed is currently contemplating a set of monetary policy changes that might be viewed as “second best”. These include yield curve control and average inflation targeting. With yield curve control the central bank would peg the yield on longer-term Treasury bonds. This was Fed policy during the 1940s. Under average inflation targeting the central bank tries to make up for an inflation undershoot or overshoot, so that inflation will average 2% over the business cycle.

In my view, these are second best policies.  Holding down long-term interest rates might be expansionary, but it also might end up being contractionary.  After all, contractionary monetary policy can easily decrease long-term interest rates by reducing expectations of inflation and economic growth.

Average inflation targeting might be expansionary during a recession, but it also might lack credibility for exactly the same reason that the current inflation targeting regime lacks credibility; there is no hard and fast commitment to make up for inflation undershoots, just an intention to try to do so.

In my view, first best policies would involve level targeting (of prices or better yet NGDP) and a “whatever it takes” approach to monetary expansion to hit those level targets.  That’s the only policy regime that would give me confidence that the Fed would actually hit its target over the very long run.

So here’s the question.  Should we view the adoption of second best policies as a step forward, even if not optimal?  Or would they be a step that makes the optimal policy less likely?  That is, would average inflation targeting involve the opportunity cost of rejecting level targeting?

What do you think?

Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment". In May 2012, Chicago Fed President Charles L. Evans became the first sitting member of the Federal Open Market Committee (FOMC) to endorse the idea.

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