Nick Rowe: Did Inflation Targeting Destroy Its Own Signal?

…the subset of firms that change their prices in any period is a perfectly representative sample of all firms… [that] makes the Calvo Phillips Curve very easy to use, which is why macro modellers like to use it. But that property stacks the modeller’s deck in favour of inflation targeting and against NGDP targeting. Because it makes deviations of inflation from target a perfect signal of monetary disequilibrium…. Inflation targeting has such desirable welfare properties… [because] the firms that can change prices do exactly what the firms that cannot change prices would like to do…. Real world central banks know… some prices are stickier… pay more attention to core inflation… ‘target the stickiest price’ is the slogan that captures this idea…. Fluctuations in inflation are a noisy signal of monetary disequilibrium, because the firms that do change prices are not always representative of the firms that don’t. And by targeting inflation the central bank makes inflation stickier, and this reduces inflation’s signal/noise ratio. Fluctuations in output are also a noisy signal…. NGDP targeting is unlikely to be exactly optimal, but may well be better than inflation targeting, which puts all the weight on one noisy signal and ignores the other…. The big puzzle of the recent recession is why the inflation guard dogs failed to bark…. The NGDP guard dogs barked loud and clear, giving a consistent and correct signal. That is what we need to model. And if we can model that, we may also have a model in which targeting NGDP can do better than targeting inflation. But we will need to move away from the Calvo Phillips Curve to build that model. Which is going to make it harder.