On the 2% inflation target

Project Syndicate asked Mike Boskin, Brigitte Granville,  Ken Rogoff and me whether 2% is the right inflation target. See the link for the other views. I pretty much agree with them in the short run -- don't mess with it -- but took a different long run view. Apparently Volcker and Greenspan were fans of price level targeting and hoped to get there eventually, which is the sort of long run approach I took here. 

I also emphasize that any inflation target is (of course) a joint target of fiscal as well as monetary policy. Fiscal policy needs to commit to repay debt at the inflation target. 

My view: 

No, 2% is not the right target. Central banks and governments should target the price level. That means not just pursuing 0% inflation, but also, when inflation or deflation unexpectedly raise or lower the price level, gently bringing the price level back to its target. (I say “and governments” because inflation control depends on fiscal policy, too.)

The price level measures the value of money. We don’t shorten the meter 2% every year. Confidence in the long-run price level streamlines much economic, financial, and monetary activity. The corresponding low interest rates allow companies and banks to stay awash in liquidity at low cost. A commitment to repay debt without inflation also makes government borrowing easier in times of war, recession, or crisis.

Electric vehicles, carbon taxes, supply and demand, virtue signals, and China

If you have not been paying attention, our government has decided that all electric vehicles are the solution to the climate problem. At least as long as they are made in the US with union labor and benefits. California has committed to banning the sale of anything else. In today's post, a few tidbits from my daily WSJ reading on the subject. 

From Holman Jenkins on electric cars:  

If the goal were to reduce emissions, the world would impose a carbon tax. Then what kind of EVs would we get? Not Teslas but hybrids like Toyota’s Prius. “A wheelbarrow full of rare earths and lithium can power either one [battery-powered car] or over 90 hybrids, but, uh, that fact seems to be lost on policymakers,” a California dealer recently emailed me.

[Note: that wheelbarrow of rare earths comes from multiple truckloads of actual rocks. Also see original for links.] 

...The same battery minerals in one Tesla can theoretically supply 37 times as much emissions reduction when distributed over a fleet of Priuses.

Writing tidbit

From Joseph Epstien's oped in the July 13 WSJ on Biden v Trump (please, dear Lord, no)

Each man has risen to the presidency thanks, mostly, to the unattractiveness of his electoral opponent. Each man was elected as a lesser-evil choice, yet both have succeeded in vastly polluting the tone of our country’s political life. Lesser-evil choices sometimes turn out to be evil enough.

Low and seedy are the corruptions of which Messrs. Trump and Biden have been accused: molesting women, entering into dubious financial dealings with foreign corporations and governments, cavalierly mishandling important documents, and more. 

My italics. I'm not here today on content, but just on writing. I make mental notes of little writing tricks that might embellish my prose.  

I liked the first one, just because it's such a beautiful catchy phrase. I'm not sure what the general principle is, but I'd like to come up with more prose like that. 

The second one has a clearer lesson. The usual rule is, write your sentences forward. Or, more likely, edit your sentences to be forwards. You should quickly turn that one around to "The corruptions of which Messrs. Trump and Biden have been accused are low and seedy." Or, better, through it changes the subject a bit, "Messrs. Trump and Biden have been accused of low and seedy corruptions." 99% of the time you should do that. 

But not this time. Look how beautiful that backward sentence is. There must be some biblical quote it refers to. Maybe readers can come up with the allusions. 

Don't do it all the time. But rules are made to be broken, if you really know what you're doing. Which Epstein clearly does. 

Freeman on Mills on IEA on battery powered cars

James Freeman's always excellent "best of the web" WSJ column today covers a Manhattan Institute report by Mark Mills itself referencing material deep in side an International Energy Agency report on battery powered electric cars. Like corn ethanol, this enthusiasm may also pass. 

The economic and environmental costs of batteries are slowly seeping out. One of my pet peeves in all of our command-and-control climate policy is that any comprehensive quantification of costs and benefits seems so rare, or at least so hidden. How many dollars for how many tons of carbon -- and especially the latter: how many tons of carbon, really, all in, including making the cars? (California only counts tailpipe emissions!) I have seen guesstimates that electric cars only breakeven in their carbon emissions at 50,000-70,000 miles. And, the point of the article, those estimates are likely undercounts especially if there is a huge expansion.  

Parts I found interesting and novel: 

For all of history, the costs of a metal in both dollar and environmental terms are dictated primarily by ore grades, i.e., the share of the rock dug up that contains the metal sought... Ore grade is what accounts for the differences in the cost per pound of gold, $15,000, and iron, $0.05. The former ore grades are typically below 0.001% and the latter over 50%.

New York Times on HANK, and questions

By the standards of mainstream media coverage of technical economics, Peter Coy's coverage of HANK (Heterogeneous Agent New Keynesian) models in the New York Times was actually pretty good. 

1) Representative agents and distributions. 

Yes, it starts with the usual misunderstanding about "representative agents," that models assume we are all the same. Some of this is the standard journalist's response to all economic models: we have simplified the assumptions, we need more general assumptions. They don't understand that the genius of economic theory lies precisely in finding simplified but tractable assumptions that tell the main story. Progress never comes from putting more ingredients and stirring the pot to see what comes out. (I mean you, third year graduate students looking for a thesis topic.) 

But in this case many economists are also confused on this issue. I've been to quite a few HANK seminars in which prominent academics waste 10 minutes or so dumping on the "assumption that everyone is identical." 

There is a beautiful old theorem, called the "social welfare function." (I learned this in graduate school in fall 1979, from Hal Varian's excellent textbook.) People can have almost arbitrarily different preferences (utility functions), incomes and shocks, companies can have almost arbitrarily different characteristics (production functions),  yet the aggregate economy behaves as if there is a single representative consumer and representative firm. The equilibrium path of aggregate consumption, output,  investment, employment, and the prices and interest rates of that equilibrium are the same as those of an economy where everyone and every firm is the same, with a "representative agent" consumption function and "representative firm" production function.  Moreover, the representative agent utility function and representative firm production function need not look anything like those of any particular individual person and firm. If I have power utility and you have quadratic utility, the economy behaves as if there is a single consumer with something in between. 

Defining the job of macroeconomics to understand the movement over time of aggregates -- how do GDP, consumption, investment, employment, price level, interest rates, stock prices etc. move over time, and how do policies affect those movements -- macroeconomics can ignore microeconomics. (We'll get back to that definition in a moment.) 

Inflation and debt across countries

Peder Beck-Friis and Richard Clarida at Pimco have a nice blog post on the recent inflation, including the above graph.  I have wondered, and been asked, if the differences across countries in inflation lines up with the size of the covid fiscal expansion. Apparently yes. 

Fiscal inflation and interest rates

Economics is about solving lots of little puzzles. At a July 4th party, a super smart friend -- not a macroeconomist -- posed a puzzle I should have understood long ago, prompting me to understand my own models a little better. 

How do we get inflation from the big fiscal stimulus of 2020-2021, he asked? Well, I answer, people get a lot of government debt and money, which they don't think will be paid back via higher future taxes or lower future spending. They know inflation or default will happen sooner or later, so they try to get rid of the debt now while they can rather than save it. But all we can do collectively is to try to buy things, sending up the price level, until the debt is devalued to what we expect the government can and will pay. 

OK, asked my friend, but that should send interest rates up, bond prices down, no? And interest rates stayed low throughout, until the Fed started raising them. I mumbled some excuse about interest rates never being very good at forecasting inflation, or something about risk premiums, but that's clearly unsatisfactory. 

Of course, the answer is that interest rates do not need to move. The Fed controls the nominal interest rate. If the Fed keeps the short term nominal interest rate constant, then nominal yields of all bonds stay the same, while fiscal inflation washes away the value of debt. I should have remembered my own central graph: 

This is the response of the standard sticky price model to a fiscal shock -- a 1% deficit that is not repaid by future surpluses -- while the Fed keeps interest rates constant. The solid line is instantaneous inflation, while the dashed line gives inflation measured as percent change from a year ago, which is the common way to measure it in the data. 

There you have it: The fiscal shock causes inflation, but since the nominal interest rate is fixed by the Fed, it goes nowhere, and long term bonds (in this linear model with the expectations hypothesis) go nowhere too. 

OK for the result, but how does it work? What about the intuition, that seeing inflation coming we should see higher interest rates? Let's dig deeper.