Marcus Nunes: A last ditch defense of Inflation Targeting

Writing a blog is like kneading bread -- you have to work it, and work it, and work it again. So we ought not be surprised to find João Marcus Marinho Nunes, reminded of his old post by one at The Everyday Economist, not surprised to see him rework his old statement and post it anew.

As it happens, I am no less fascinated than Nunes by his topic. So I am happy for the chance to review his most recent thoughts on the subject. My review will consist of three parts:
1. Summary of his post.
2. Summary of the summary.
3. An "alternative view" of my own.

1. Summary of the post

Nunes opens with a quote from Roger Farmer, describing "increased responsiveness" of the Federal Reserve to inflation during the Great Moderation:

After 1983, the inflation-reaction coefficient increased; the Fed raised the short-rate by a larger percentage in response to inflation than it had done in the period from 1951 through 1979.

As if in response, Nunes quotes Anasthsios Orphanides:

But if policy is to be evaluated based on information that was actually available when policy decisions were made, a different conclusion emerges.

In other words, if we evaluate the policy decisions of the 1970s based on information available at the time, those decisions were no less "responsive" than those of the Great Moderation. As Nunes puts it,

...when using data available to policymakers in real time, monetary policy during the 1970´s was characterized by a rule that is consistent with the estimated rules for the period after Volker

Orphanides, if his information is correct, undermines Roger Farmer's view and, as Nunes points out, undermines the "consensus view" as well. This opens a door to an alternative analysis.

The alternative Nunes presents is that there was a change of "doctrine" at the Fed when Paul Volcker took the big chair in 1979. Under Fed chairman Arthur Burns in the 1970s, inflation was seen as cost-push, arising from forces beyond the Fed's control. But Volcker challenged that, seeing inflation as demand-pull. According to Volcker, "the inflation process is ultimately related to excessive growth in money and credit”.

So, where Arthur Burns was willing to accommodate the forces that were pushing prices up, Paul Volcker was not. A change of doctrine.


On the 27th I wrote:

I like to read Nunes because he will often add a parenthetical phrase that works, for me, to make sense of a technical concept.

Now I can give you an example. Here's a paragraph from Nunes' post:

An alternative view of the change in monetary policy from the Great Inflation to the Great Moderation is that there was a change in the “doctrine” of the Federal Reserve. According to Robert Hetzel, during the period of the Great Inflation, the prevailing view, and the one embraced by Arthur Burns, Fed chairman from 1970 to 1977, was that inflation was a real (cost-push), and therefore non-monetary, phenomenon.

If Marcus didn't include "(cost-push)" there, I would not have known what that last sentence meant. But now I *do* know. And I like the concept of seeing "cost-push versus demand-pull" in terms of "real versus monetary". And I really like the way Marcus defines "real" by distinguishing it from "monetary". I think the clarity he provides can help answer questions like Why Does Y Equal Real GDP?

I do like reading Nunes.


Marcus Nunes identifies the cost-push view of Arthur Burns as "Keynesian orthodoxy". (I could not have guessed that. No matter.) Anyway, he looks at the cost-push view and ties it back to the discrepancy that opened the door to his alternative analysis:

This “cost-push” view of inflation, together with an SAS perceived as horizontal when output is below potential, can explain the observed differences in the estimates of the parameter on inflation in the Taylor Rule during the Great Inflation and the Great Moderation.

"Under the cost-push 'doctrine'", Nunes writes, "forecast[s] of inflation based on the ... Phillips Curve" would be systematically under-estimated because "after the negative supply shock output is below potential and unemployment above the NAIRU."

The Phillips Curve identified a trade-off between inflation and unemployment. But then, "SAS perceived as horizontal" implied that output could be brought up again (by increasing Aggregate Demand) without causing inflation -- because the flat SAS curve predicted supply increasing while prices remain stable. But since this (horizontal SAS)^* notion was flawed, inflation kept turning out worse than predicted.

*   Nunes explicitly identifies the Phillips curve as the flawed mechanism. Not the horizontal SAS. But I can only make sense of Nunes' remarks by assuming he misplaces the error.

Nunes concludes the thought by referring back to the discrepancy Orphanides observed:

The fact that inflation was systematically under forecast implies that estimates of the Federal Reserve reaction function as measured by the Taylor Rule using real time data [concur] that the Fed had a much stronger response to inflation than the response obtained using “final” data.

He then moves on to the next piece of his analysis:

So, if during the Great Inflation the Fed did not under react to inflation, given real time data – the error coming from a flawed forecasting mechanism – The Phillips Curve – how come the Great Moderation emerged? In other words, how did Fed “doctrine” change and why was this new “doctrine” consistent with reduced volatility in both inflation and real output growth?

"On becoming chairman of the Fed," Nunes writes, "Volker challenged the Keynesian orthodoxy":

Volker´s challenge placed inflation as the FOMC´s top priority. He also brought to the fore of policy discussions the ideas developed during the previous 12 years – since Friedman´s address to the 1967 AEA meetings – on the importance of inflation expectations.

This view, an overhaul of Fed doctrine, implicitly accepts that rising inflation is caused by “demand-pull” or excess aggregate demand or nominal spending.

Before the change in doctrine, policymakers thought they could increase Aggregate Demand to boost the economy, without contributing to inflation (because they thought inflation had other causes, cost-push causes).

After the change in doctrine, policymakers held that inflation is related to the quantity of money (or, to the growth of the quantity of money) and, excuses be damned, that they could control inflation by controlling the quantity of money. This brings us back to Roger Farmer's quote, from the opening of the post:

Volcker followed a policy of strict control of the money supply, as opposed to control of the interest rate. This policy rapidly reduced inflation at the cost of a period of high interest rates and a big spike in unemployment.

"Volker," Nunes writes, "believed that inflation was the result of excessive AD."

So nothing more natural than to assume that the Fed should increase its responsiveness to the growth in nominal spending. How would this change in “doctrine” (from regarding inflation as a “cost-push” to “demand-pull” phenomenon) show up in the data?

This is the best part of Nunes' post. He reminds us that

under the cost-push “doctrine” the Fed would react vigorously to negative output gaps making policy expansionary, so nominal spending would grow.

But under Volcker's "demand-pull" doctrine,

the Fed doesn´t react much to supply shocks ... but would react vigorously to AD or nominal spending shocks.

"Therefore," Nunes concludes, "under the new “doctrine”, policy would make AD growth stationary, in which case AD growth will not show a rising trend as under the cost-push “doctrine”. The chart illustrates."

And then Nunes displays the chart -- the chart that is the reason I'm still analyzing and evaluating his post, after more than a week:

Source: M. Nunes, A last ditch defense of Inflation Targeting

"The main difference between the two 'doctrines', Nunes writes, "is not the change in the Fed´s responsiveness to inflation as argued by Taylor, Bernanke or Farmer, but the changed responsiveness to aggregate demand or nominal income growth." Moderation in inflation and output volatility, he says, would be a "collateral effect".

Finally, tying back to his post title, Nunes writes:

The Fed never explicitly targeted anything – inflation or nominal income (AD) growth – but implicitly you could say it targeted nominal AD along a 5.5% growth path growth after Volker.

2. Summary of the Summary

Good economics is like good science fiction: The story doesn't have to be true, as long as it is interesting. One needs to suspend disbelief. That lets you take in the whole thing, and evaluate the whole. James Bullard's remarks from back in February, which I reviewed beginning here, is one example of this kind of good economics. Marcus Nunes' post is another.


In my day job I take drawings from customers and make drawings for the shop, so the shop can make what the customer wants. It's a good job. Sometimes it is difficult to figure out what the customer wants. So I will make a guess about what he shows me, and proceed on that basis. What I do then is look for discrepancies. If I made a bad guess, there will be discrepancies and I will know. If there are no discrepancies and things fall into place, then I can figure my guess was a good one.

Discrepancy analysis is a useful tool.

Marcus Nunes opens his post with a look at the "consensus view" of how the Great Moderation emerged. He points out a discrepancy in this view, regarding the Fed's "responsiveness" to inflation. Because of the discrepancy, Orphanides' discrepancy, Nunes says the consensus view (represented by Roger Farmer's statement) is a bad guess.

Nunes then makes a new guess. His guess is that "there was a change in the 'doctrine' of the Federal Reserve" -- a change from thinking in terms of cost-push, to thinking in terms of demand-pull. The old doctrine led to low-ball predictions of inflation, so that (based on what we know today) the Fed's policy responses seem weak when compared with "new doctrine" responses.

The analysis explains the discrepancy Orphanides observed. This makes a strong introduction for the "alternative view", for the guess Nunes provides. At this point, Nunes asks: "So ... how come the Great Moderation emerged?"

The new doctrine challenged the old, Nunes says, and "implicitly" accepted that rising inflation is caused by demand-pull. Nunes writes:

To Volker, the policy adopted by the FOMC “rests on a simple premise, documented by centuries of experience, that the inflation process is ultimately related to excessive growth in money and credit”.

Volker ... believed that inflation was the result of excessive AD.

The new doctrine assumed that control of the growth of money would enforce control upon inflation. And it proved true, if we may judge by the result. The result of the change in doctrine, Nunes says, is visible in the change in nominal spending growth, visible in the chart he provides.

Me, I love graphs, and logic, and when Nunes' logic led to that graph, well, I was flabbergasted. But there comes a time when the suspension of disbelief has to be terminated.

Marcus Nunes' whole argument, good as it is, is built upon on the change of doctrine, the change from thinking of inflation as cost-push to thinking of it as demand-pull.

And judging by the results, Volcker was apparently correct when he said "the inflation process is ultimately related to excessive growth in money and credit". Treating inflation as if it was demand-pull reduced inflation significantly.

But what if Arthur Burns was right? What if the inflation was in fact cost-push? Treating it a demand-pull, suppressing money, would hinder the rise of prices. But it would do nothing about cost-push pressures, those real (as opposed to monetary) pressures that were driving prices up.

With cost-push pressures ignored, they could fester for decades while economic performance deteriorated. Meanwhile, to circumvent that deterioration a whole new system of supply-side policies would have to be put in place. However, with cost-push pressures ignored, inflation would never really go away away.

3. Unsolicited Afterthoughts

Arthur Burns was wrong. Oh -- not about inflation being cost-push. He was right about that. But according to Nunes, Burns identified the push as "pressure on costs arising from excessive wage increases". Wage-push inflation. Burns was wrong about that.

Hey, if wages were the driving force, then wages would have been gaining relative to other costs. Wage-earners would have been doing better, not worse. So there is no way wages were the driving force behind this inflation. And I can show it to you, too:

Interest Costs Rise as Employee Compensation Falls

Wages -- the red line -- were not increasing as a portion of corporate costs. Wages were falling. It was interest costs that were rising. Financial costs. The blue line. That's what was pushing prices up. Not wages. And look what that got us, thirty-odd years later: wage-earners deep in debt, and a financial sector grown too big to fail.

// UPDATE 6 October 2015: Fixed a graph that was not displaying.