Posted by: Dirk | January 27, 2010

Monetary policy goes boink

The US inflation rate is coming up again, approaching 3%. Time to think about an exit-strategy, the NY Times reports:

Now that the economy is on the mend, the Federal Reserve this year can focus on how and when to pull back the stimulus money pumped out to fight the financial crisis. With his prospects for another term brightening, Ben Bernanke will lead that effort.

At their first meeting of the year, Fed policymakers are likely weighing such matters, including which tools to use. The officials are slated to issue a policy statement Wednesday when they wrap up their two-day session.

The question that occurs to me is what monetary policy in the future will be based on. By now it is clear that unemployment is still high, at around 10%. The theory behind inflation-targeting – the New Neo-classical synthesis – assumes that output and inflation gaps always open up and close together. Which did not happen. Inflation is back at where it should be, but unemployment is unacceptably high. So my question to Ben Bernanke would be: Given that you have only one instrument (the interest rate) and two goals (closing inflation and output gaps), which goal will you aim at?

UPDATE 29/01/2010: This is an extract from Woodford/Curdia (2009), Conventional and Unconventional
Monetary Policy
, p. 33, my highlighting:

In the case considered, if the financial disturbance were never to occur, optimal policy would involve maintaining a zero inflation rate, as this would also imply a zero output gap in every period. After the disturbance dissipates, one of the feasible policies is an immediate return to this zero-inflation steady state (under the parameterization assumed in the figure, this involves a nominal interest rate of 4 percent), and this is optimal from the point of view of welfare in all of the periods after the financial disturbance dissipates.

On page 46 in the conclusion Woodford acknowledges the specific assumptions on synchronized inflation and output gaps (again, my highlighting):

At least in the context of the simple model of credit frictions proposed here, optimal interest-rate policy can be characterized to a reasonable degree of approximation by a target criterion that involves the paths of inflation and of an appropriately defined output gap, but no other endogenous target variables.

So, stagflation (inflation+stagnation) would be something that the model could not handle. But we had stagflation in the 1970s…

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