I feel sometimes like a lonely defender of the Bernanke Fed, against a growing chorus of mainstream economists on one side who think a too-tight monetary policy is the main reason unemployment has remained stubbornly high, and Austrian goldbugs on the other side who see the Fed’s extraordinary interventions since the start of the financial crisis as the reason the economy hasn’t healed itself yet. Apropos of expectations of a new round of quantitative easing, and renewed debate on whether the Fed should shift to an NGDP target, I’ll rehash my reasons for basically believing the current paradigm is the right one.

The Fed’s view for the past generation has been that it can best fulfill its dual mandate – stable prices and full employment – by focusing primarily on the first half of its mandate, on the theory that predictable and stable prices will do the most to promote predictable and stable growth.

In theory, NGDP targeting takes a similar view. Again, we are to focus on one number – not inflation, but nominal GDP, which includes both inflation and real growth, but is actually an easier number to measure than either of the numbers we tend to break it into. Businesses, after all, make their investment and hiring decisions based on forecasts for growth in nominal demand (and projected rises in the nominal cost of inputs like materials and wages). If overall nominal growth is stable, then planning becomes much easier.

My problems with using NGDP rather than inflation as a target are as follows.

First, NGDP targeting is usually advocated in the context of advocating a “catchup” plan. Because we went through a period of deflation and contraction, the price level is now under trend, and the Fed should commit to remaining maximally loose until we’ve caught up with the price level.

But, if NGDP really is a new framework, and not just a rationale to keep monetary policy loose, to be discarded when conditions change, then we have to look back at how it would have worked in a period of high nominal growth – and high inflation. Moreover, we’d have to look at how “getting back to trend” would have worked once the back of inflation was broken.

And it seems to me that it would have worked disastrously. From 1965 to 1980, nominal GDP growth never dipped below 6%, and got as high as 12%. To return to “trend” would require keeping nominal GDP well below the economy’s potential for years. You remember “Morning in America?” Well, if we were following a nominal GDP target it would never have happened. The Fed would have raised rates sharply in 1984, as nominal GDP growth spiked up from 6% all the way to 10%.

Of course, nobody would have followed such a policy, even if, in theory, there were some advantage to “undoing” the “Great Inflation.” A policy of “opportunistic disinflation” was much more rational, precisely because much more moderate.

That’s obvious. So why isn’t it obvious that the converse is true? That, just as Volcker’s goal properly was the break the back of inflation, not to reverse its effects, Bernanke’s goal properly was – and is – to break the back of deflation, not to reverse its effects?

And what evidence is there that accelerating inflation can benefit the economy? The usual example cited is Roosevelt’s suspension of the gold standard. But this broke the back of deflation; it did not suddenly create accelerating inflation expectations. Inflation from 1934 to 1937 averaged 2.7% – a huge change from the preceding deflation, but hardly a catch-up rate. It might be that higher inflation would have been even more beneficial, but my point is that Roosevelt’s action doesn’t prove that (nor disprove it). It proves that an end to outright deflation, and a return to rising prices, is beneficial. Which I agree with.

The most interesting implication of NGDP targeting, one that I have come to agree with, is that supply shocks should not drive monetary policy – or should drive it the opposite way than you’d think. A spike in oil prices, which pushes up inflation, should lead to easing, not tightening, because it also causes a hit to real growth, and the second effect dominates, resulting in a lower NGDP. Conversely, a positive supply shock like a sudden drop in oil prices should lead the Fed to tighten, not loosen. This sounds counter-intuitive, but it actually makes sense, and a traditional monetarist who wasn’t an NGDP-targeter wouldn’t disagree, because supply-driven changes in oil prices aren’t monetary phenomena, and hence can’t cause a change in overall inflation expectations. It’s interesting to contemplate how Fed policy might have been better in 2007, had it not been spooked by rapidly rising commodity prices.

On the other hand, nominal growth has historically been quite a bit more volatile than the inflation rate, so an NGDP target would require a much more volatile Fed – or one that was much slower on the draw. And NGDP expectations have been more volatile still – and it’s never been clear what metric the Fed would use to measure those expectations. Again, “NGDP targeting with catchup” would be very easy to implement right now, because it would just mean keeping the money spigots open. But once economic conditions change, it’s not so clear how well the framework would work.

Then there’s the problem that NGDP targeting implicitly assumes that we know what the long-term real growth potential of the economy is. Scott Sumner, one of the most capable exponents of NGDP targeting, says I have this backwards, but I think he’s confusing the short with the long term. A 2% inflation target is a prudential measure, based on the assumption that we want to get as close to zero (true price stability) as possible without dipping under. I understand the logic of it. Where does a 5% NGDP target come from? Implicitly, it comes from a 3% real growth potential plus 2% inflation. But where does the 3% come from? How do we know that our economy can continue to grow at 3% per year? How do we know that its real potential isn’t lower – or higher? Suppose technological advances push productivity way up. Why should the Fed raise interest rates in response? Suppose a drop in population growth and a slow-down in technological advance pushes the real growth potential of the economy below 2%. Why should the Fed remain persistently looser in response? I understand the logic behind the NGDP-targeting approach to supply shocks. I don’t understand the logic behind the NGDP-targeting approach to changes in productivity and labor-force growth.

Moreover, the whole idea of targeting nominal GDP assumes the Fed is able to command an increase in inflation. Which, I agree, it can do – but it can’t do it without side effects so long as we have a cash economy. In a theoretical world where there was no cash, the Fed could push the Fed Funds rate to negative levels, which it seems reasonable to assume would have similar effects to a cut in rates under normal, positive-rate conditions. In the world we live in, the Fed has to buy up other assets – longer-term government bonds, primarily – in order to further loosen monetary policy. But this isn’t really the same thing as lowering the Fed Funds rate, and it has a variety of distorting effects on both investment decisions and the behavior of the Treasury.

And some of the main channels by which the Fed affects consumer behavior are blocked right now, preventing monetary policy – even extraordinary policy such as the Fed has been following – from being effective. So long as we have a huge overhang of nonperforming mortgages, refinancing will be difficult. But refinancing is the main mechanism by which the Fed can drive an increase in demand. This may be changing as the housing market recovers, but if so it still proves my point that depending on conditions in the “real economy,” monetary policy may be more or less effective in affecting real growth. That being the case, targeting NGDP isn’t as simple as it sounds.

I think a policy of “opportunistic reflation” – being somewhat less-vigilant about fighting inflation so long as we remain under the long-term price trend – makes sense in current conditions. It would also make sense for Bernanke to say that improvements in the productivity of the real economy should give the Fed more room to keep monetary policy loose without worrying about inflation. That would be a signal to the market that the Fed is looking for good policy to help it out, and not planning to choke growth off as soon as it appears – which would remove a source of uncertainty. But these do not constitute a radical change in framework, just a change of emphasis within the existing framework, a change that recognizes that recession and outright deflation remain real risks, and that we need to be more vigilant about these than about inflation. That’s a change that has already taken place to some extent, and the evidence is that the Fed continues to use non-traditional monetary policy to insure that we don’t fall back into recession. It would be a good idea, from an expectations perspective, for the Fed to make that change of emphasis clear, but again, that doesn’t require a shift in framework.

More generally, I agree with economists like Joseph Stiglitz and Jeffrey Sachs that focusing too much on monetary policy is a distraction from the need to address the economy’s structural problems – from the overhang of mortgage debt to wasteful spending on health care to the collapse in manufacturing to a backlog of basic infrastructure needs – which must be addressed for the real economy to improve in a sustainable fashion. These structural problems can be tackled with a view to improving the short-term employment situation, rather than in a way that ignores that situation. But they have to be addressed for the economy to sustainably improve. A monetary-driven expansion in the absence of such an effort will just lead to another crash down the road, and progressive erosion of real wealth.