Occasionally I find myself including "thoughts" in post titles. Sometimes the post is a series of notes which don't quite indicate a clear story line. In many instances, my ideas regarding the subject may still be evolving. That's certainly the case for income aggregate roles in the context of a monetary target. When it comes to determining the potential of income formation in relation to resource use, there's still plenty of work to be done.
While I believe income aggregates are central to a nominal target, I don't believe their representation is well suited as a single target. Other resources - in relation to the relatively fixed constants of income and time use - constantly change in value, quantity and production definition. One beneficial aspect of a nominal target, is that it is also capable of keeping income aggregates in a direct relationship with both production and consumption.
Oddly enough, targeting income alone can distort this relationship. Why? Over time, supply shocks - both positive and negative - can still pull income aggregates away from their optimal trajectory. In this respect, targeting income would present problems which are similar in nature to a price level target. Patterns of resource utilization in relation to income capacity are difficult to discern, without the assistance of a nominal target to guide the monetary course between these aggregates.
Inflation targeting has gradually contributed to a relative loss of income and time aggregates, in terms of labor force participation. To a degree this loss is also recognized as "stagnant" income. Unfortunately, IT caps spending capacity without considering income and consumption relationships in general equilibrium. This makes inflation targeting less effective than either income or price level targeting. When income factors for aggregate spending capacity are missed - as has increasingly become the case - disinflation can eventually become real deflation in national settings. Diminished income also contributes to gradual downshifts in production capacity and services formation.
Aggregate spending capacity includes both income and consumption factors, in spite of the consumption context which so often dominates the discussion. However, fulfilling aggregate demand is just as important for the role of income, as for consumption. Both production and consumption need to remain flexible to overcome the problem of sticky wages, in particular. Flexibility in production roles is also key for reversing the recent decline in labor force participation.
Even though supply side representatives need to maintain production flexibility in terms of product definition, monetary authorities also need to provide greater flexibility in response to supply side shocks by refusing to overreact to headline inflation. Doing so would also protect income aggregates which are more closely aligned with core inflation.
When central bankers rely on discretion to second guess supply side movements, they forget that supply side representatives don't always have the capacity to define the marketplace conditions of the commodity in question. As a result - by overreacting to headline inflation - central bankers can make matters worse all around. Sometimes, they inadvertently reduce both aggregate spending capacity and total income potential, whether a supply shock is perceived as positive or negative in the marketplace.
Undue reaction to supply side circumstance is a major contributor to bad deflation. This form of deflation results in decreased spending capacity, rather than gains in income potential. While some economists see little problem with deflation in general, deflation which decreases consumption potential over time remains a primary issue for developed nations. Hence it helps to ask when assessing deflation factors: to what extent are they caused by further erosion in income capacity?
Core and headline inflation are particularly important in relation to income, because changes in headline inflation do not accurately reflect income aggregates. Hence one of the dangers of emphasizing headline inflation as opposed to core inflation, is that one makes the very real danger of moving the goalpost away from the consumption potential of current income aggregates.
It is understandable that central bankers wish to maintain considerable discretion in all that they do. And granted, the possibility of a nominal target rule is still contrast with other rules which would only take the Fed further off course. However, inflation targeting continues to leave the Fed unnecessarily exposed, by making their job far more complex than would otherwise be the case.
Responding to headline inflation during strong shocks with discretionary action, is like standing in the full force of a hurricane instead of seeking cover. Inflation targeting in particular leaves central bankers "outdoors" in the elements: buffeted by the high winds of opinion, second guesses and unnecessary risks. Why not choose the relative safety of a nominal target, or simple core inflation at the very least? Why take unnecessary chances, when the odds are good that by remaining inside the bounds of more reasonable options, everyone could remain safe? Why, indeed.
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