I want to pick a very small fight with Paul Krugman. And I want to get my head clearer on something. (It's still not clear, so read at your own risk.) So I'm writing this post.
"The problem, at least in part, is that the indirectness of Bernanke’s language, the way an inflation target is implicit rather than explicit, feeds the confusion. I understand what he’s doing: a lot of people aren’t ready to face the realities here, so blurriness has its uses (and so do other targets, like nominal GDP, that are ultimately mainly about inflation but don’t make that point explicitly). But there are costs to this vagueness, and we’re seeing some of them already." (my bold)
Agreed that the Fedspeak is not as clear as it should be. But I don't think that an NGDP target really is ultimately mainly about inflation. A higher NGDP target is like a portfolio of inflation and real growth, and when you are uncertain a portfolio of two assets is usually better than a single asset. Eggs and baskets stuff.
There are four things we don't know:
1. We don't know the slope of the Short Run Phillips Curve. And we don't know what people believe about the slope of the Short Run Phillips Curve. If the SRPC is (believed to be) steep, an increase in (expected future) NGDP will mean a large increase in (expected) inflation and a small increase in (expected) real growth. If the SRPC is (believed to be) flat, an increase in (expected future) NGDP will mean a small increase in (expected) inflation and a large increase in (expected) real growth.
2. For a given nominal interest rate, and increase in expected inflation will cause a decrease in real interest rates and an increase in Aggregate Demand. For a given real interest rate, an increase in expected real growth will cause an increase in Aggregate Demand (because people and firms want to consume more and invest more if they think future real incomes will be higher). But we don't know the relative strengths of these two effects.
3. An increase in expected inflation will cause an upward shift in the Short Run Phillips Curve. In the Calvo model a 1% increase in expected inflation will cause an immediate 1% upward shift in the SRPC. In a different model, with more inflation inertia, it will take longer for a 1% increase in expected inflation to cause a 1% upward shift in the SRPC. And we don't know which model is right, and so we don't know how quickly and how much the SRPC will shift up if expected inflation increases by 1%. (Though we think we know it will eventually shift up by exactly 1%.)
4.Short run "supply shocks" (perhaps better described as "price shocks") can cause the Short Run Phillips Curve to shift independently of any shift they cause in the Long Run Phillips Curve. We do not have a good theory of how short run supply shocks shift the SRPC. And we do not know what short run supply shocks there will be in the near future. So we do not know how big an increase in inflation would be consistent with getting the economy to the Long Run Phillips Curve.
If we did know all those four things, It wouldn't matter which language the Fed spoke. We would know how much inflation would be associated with a higher level of NGDP, and vice versa. We could translate inflation Fedspeak into NGDP Fedspeak, and translate NGDP Fedspeak into inflation Fedspeak. It wouldn't be correct to say that an NGDP target is "ultimately mainly about inflation". Nor would it be correct to say that an inflation target is "ultimately mainly about NGDP". It would be correct to say they are different ways of saying the same thing.
But we don't know those four things. And even if we economists did know all those four things, regular people might not. And the main point of Fedspeak is to communicate with regular people. So we cannot translate back and forth between an inflation target and an NGDP target. The Fed's language matters.
Which language is best?
I wish I could build a neat little model with parameter uncertainty to show which is best. But I can't. I can only sketch a heuristic argument.
An inflation target to escape the Zero Lower Bound seems like putting all your eggs in one basket. Expected inflation goes up, expected real interest rates go down, Aggregate Demand goes up, actual inflation goes up, and validates the increase in expected inflation. And real income goes up, maybe by just the right amount, or maybe too little, or maybe too much. It could be far too little, or far too much, if we are wrong about the slope and position of the Short Run Phillips Curve, or about the strength of the real interest rate effect.
An NGDP target is more like putting half your eggs in the inflation basket and half your eggs in the real growth basket. One basket should work, even if the other fails. The two baskets are even negatively correlated, via the uncertain slope of the Short Run Phillips Curve. It should be more likely to work, and work by roughly the right amount.
That's the best I can do, for now.