Do we have a problem if it works?
Recently I have become more positive on the outlook for the European and US economies. It seems like the ECB has finally recognised that it need to ease monetary policy to avoid a deflationary disaster and judging from the development in broad monetary aggregates in the US there are signs that things are also moving in the right direction in the US economy. If investors and consumers are jumping on the happy-go-lucky bandwagon then we might even see the money velocity in the US and the euro zone begin to inch up. If both broad money supply growth is picking up and velocity would be inching upward then nominal GDP and inflation would also be accelerating and as any Market Monetarist will tell you expectations are key so the recovery could be very swift if market participants start to think that central banks are willing to accept as short-term pick up inflation to achieve a higher level of NGDP. Lets be really optimistic and say that US inflation jumps to 5% in the coming half year and real GDP also increases to 5% (there are no signs that that is happening). That would give us 10% NGDP growth and we would finally be closing the “NGDP gap” and start to return to the pre-crisis trend. What would happen in that situation? Well, some of us would happy, but there is no doubt that the fears of “runaway inflation” would increase. As somebody asked me the other day “will you be able to stop inflation getting out of control if you have 2 years in a row with 5 or 7% inflation?” My answer was “Clearly!”, but I must also admit that I am more worried than that answer reflected. Hence, in my view there is a real risk that if monetary policy is eased in the present “stealth” fashion then it will be much harder to anchor expectations – and more importantly it might be harder to get policy makers back to the idea that high inflation is bad. No, please do remember that we are not inflationists. Inflation is bad - at least demand inflation is bad. Therefore, I think that even if nominal GDP growth starts to pick up I think is extremely important that we keep arguing in favour of NGDP level targeting. We don’t want “stimulus” to bring us out of the present mess. No, we want a monetary regime that ensures us against ever to get into this situation again. So yes, we should clearly argue for monetary easing now, but it is much more important that sound monetary regimes are implemented. Lets say I had the choice between increasing euro NGDP with 15% right now but also maintain the overall present monetary regime in Europe (with all its faults) or have a monetary regime based NGDP level targeting (but from present levels) then I surely would prefer the later.