Inflation targeting in monetary policy has people against it and people for it. I am for it.

It is good to have stable inflation. The economy can grow much better.

But I do put the blame on low inflation targeting for real wages being stagnant for decades. I will explain below. The main idea is that the Fed rate reacts to inflation in such a way as to deny healthy increases in unit labor costs.

First, I think an inflation target of 2.0% is too low. It encourages lower rates of labor share of income. This graph shows that as the economy settles into lower rates of inflation, labor share and utilization rates of labor and capital (TFUR) slide down to the left decreasing.

We have seen labor share and capacity utilization slowly drift downward over the years. Inflation rates have also drifted down over the years. The Fed rate drifts down too. The graph above shows with low inflation targets, the economy settles downward to lower rates of all variables, which makes the economy ultimately more vulnerable. As we have seen.

So I do not want to give my equation for monetary policy too much power over inflation rates. Inflation needs to have some freedom to move and then come back naturally into equilibrium. I do not want a model that overreacts to changes in inflation.

In fact, the effective labor share (els) variable in the equation already takes into account the existing inflation rate with its relationship to unit labor costs...

Effective labor share = unit labor costs/price level

There may be no need then to explicitly incorporate a mechanism in the equation to always automatically control rising inflation with no regard to context for that inflation. Let's then evaluate different equations in how they react to inflation. We start by looking at an equation that reacts strongly to inflation...

ED rule = z*(TFUR^{2} + els^{2}) - (1 - z)*(TFUR + els) + inflation rate - 2*inflation target

Here is the graph for the equation plotted against the actual Fed rate...

The red line is actual Fed rate since 1988. The yellow line is the above equation for the Effective demand rule. The purple line is a moving 3 quarter average. If the Fed rate was to follow the ED rule path, it would jump around quite a bit. What is the purpose too of the equation calling for a rise in the Fed rate during the 3% inflation of 2011? Is the equation trying to control inflation from below the 0%? It is silly and the Taylor rule shows the same rise in the Fed rate.

So then I lower the coefficients on the inflation variables to weaken the mechanism to control inflation...

ED rule = z*(TFUR^{2} + els^{2}) - (1 - z)*(TFUR + els) + 0.5*inflation rate - 1.5*inflation target

The graph changed to this...

The light green line is the revised equation. The dark green line is a 3-quarter moving average. You can see that the path of this revised ED rule is more steady. The path shows less reactivity to changes in inflation. That is to say that inflation can bounce around and this equation will not react as much.

Now if I was to take out the mechanism to control inflation all together and just use the inflation target, the equation would be this...

ED rule = z*(TFUR^{2} + els^{2}) - (1 - z)*(TFUR + els) - inflation target

And the graph would look like this...

This smoother path for the Fed rate would be lower overall meaning a tendency for monetary policy to be looser, which would allow higher and more volatile inflation rates. This path reacts to rises in the inflation rate through the effective labor share (els) variable, depending on how unit labor costs change. If unit labor costs rise relative to inflation, then this equation would raise the Fed funds rate. If unit labor costs fall relative to inflation, then the Fed funds rate would drop. (holding other variables constant)

We can also see that during the 3% inflation of 2011, this equation did not react to tighten monetary policy like the first equation above. It was correct to not react to that inflation of 2011. The inflation eventually came back down because it was not supported by a rise in unit labor costs. This last equation is behaving much better.

From 2005, inflation rose, so the Fed rate was raised. But unit labor costs actually didn't rise as much relative to inflation. By pushing inflation back down, unit labor costs were kept from rising as they naturally wanted to. This has been the problem with the Fed rate over the years, and why I think this last equation is the best for determining the Fed rate. This last equation allows inflation to move, but only reacts if effective labor share (els) changes. And effective labor share will change if there is a change in the relationship between inflation and unit labor costs.

When effective labor share increases, effective demand increases, which gives more room for economic growth. Yet, the Fed rate will want to increase to hold labor share constant. The beneficial effect is to keep unit labor costs in line with inflation. Whereas traditional monetary policy looks to have just kept inflation low stifling socially beneficial adjustments to unit labor costs.

This last equation would have allowed unit labor costs to rise more with inflation over the years, which would have been a healthy thing for the economy. You only need to be careful when you are near the effective demand limit (LRAS curve). In which case, you could have an inflation spiral upwards. But you just keep an eye on where the effective demand limit is. A lower Fed funds rate before the crisis would have created pressure to raise real wages and to raise unit labor costs, which the economy needed for balance and long-term health.

So in my opinion, the best equations to determine the interest rate of monetary policy correspond to the last graph and they are...

ED rule for Fed rate path = z*(TFUR^{2} + els^{2}) - (1 - z)*(TFUR + els) - inflation target

ED limit = 2 * z * TFUR^{2} - 2 * (1 - z) * TFUR - inflation target

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