How Would You Know?

How would you know if central banks were impotent at the zero lower bound?

You would have them target some nominal variable and then see if they can achieve that target. Wait, every central bank that I can think of off the top of my head does this: the Federal Reserve, BOJ, BOC, BOE, and the ECB. So, given that all of these central banks have had limited success at keeping inflation on target, monetary policy seems to have been pretty impotent.

Even if we restrict the analysis to countries that adopted the inflation target during the zero lower bound period (i.e. the BOJ and the Federal Reserve), we would find the same result: since the new target was adopted, in both cases 2% inflation, the target variable has been consistently below target.

Of course, all the market monetarists will respond by basically saying that inflation is always on target, so the recent experience only means that central banks are liars. This proposition is so ridiculous that I refuse to comment further on it.

For the remaining sane people in the room, the failure of inflation targeting central banks to have inflation on target is an indication of the ineffectiveness of monetary policy at the zero lower bound. Specifically, chronically low inflation means that the ability of central banks to loosen monetary policy (whatever the heck that means, everyone please stop referring to undefined terms like the 'stance' of monetary policy) has been severely limited over the last 8 years.

Actually, I do want to comment a little bit on the aforementioned ridiculousness. If your view is consistent with any empirical outcome, then it is unfalsifiable and should probably be ignored. Then again, this is probably true for the majority of economics, which is why your opinions, along with those of Post Keynesians, Austrians, and probably yet other heterodox school that I have never heard of, still exist.

Why can't we (unfortunately, I might add) reject market monetarism based on the last 8 years? Because if we did that, we'd also have to reject all the good theories like the Phillips curve, sticky prices at the individual firm level, Marshallian labor markets, etc.

Scott Sumner Claims His Model is Wrong by Claiming His Model is Right

I wrote a blog post a couple of days ago wondering if nominal GDP targeting and inflation targeting are the exact same thing. I came away with two conclusions: if sticky consumer prices are the primary source of nominal rigidity, then the answer is yes and if sticky input prices and/or prices not included in the central bank's target price index are the primary source of nominal rigidity then the answer is no. Implicit in these two conclusions is that real GDP is always at potential under an inflation targeting regime in sticky-consumer-price models and that real GDP is not often at potential in sticky-input-price models.

So, where does Sumner fit in to this? Well, Sumner recently read this post on Canadian austerity in the 1990s by Stephen Williamson. He noticed that Williamson sees adherence to an inflation target as evidence against monetary offset, so he decided to write this wonderfully contradictory statement:

If you observe the inflation rate always being on target, then the central bank is successfully offsetting any fiscal action that would have otherwise moved AD and inflation.

Of course, this statement is perfectly sound a-cyclical inflation targeting results in a constant output gap of zero, but that's not the way that Scott Sumner sees the economy. Being a market monetarist, he believes that counter-cyclical inflation targeting is consistent with a constant output gap of zero. If an inflation target is optimal, then monetary offset did occur in Canada, but if a nominal GDP target is optimal, then monetary offset did not occur in Canada. Since even friction-less models suggest that the multiplier on government spending is greater than zero (pdf), it's pretty obvious that monetary offset did occur in Canada, but this basically discredits the already somewhat scarce theoretical evidence for market monetarism.

It seems that two of Sumner's strongest positions are not consistent with each other. Either monetary offset happens in an inflation targeting regime or nominal GDP targeting is optimal.