I think my last post was very clear. Inflation targeting failed. I know this post won't be clear. But this post tries to answer the question that my last post begs to be answered. Why did inflation targeting fail?
I used to think that if the Bank of Canada succeeded in keeping inflation on target, there wouldn't be deficient-demand recessions. There might be falls in output and employment due to droughts, earthquakes, plagues of locusts, and other supply shocks, but there wouldn't be falls in output and employment due to deficient aggregate demand. Unless the Bank of Canada's crystal ball failed, so it let inflation fall below the 2% target, which would cause a deficient-demand recession.
I was wrong. The Bank of Canada did keep inflation almost exactly at the 2% target, but there was a deficient demand recession.
If you had told me in 2008 how long the recession would last in many countries, I would have predicted that inflation would have fallen a lot in those countries. It didn't fall a lot. In some countries, like the UK, it didn't fall at all. I would have been wrong.
It didn't use to be like this. In past recessions, absent significant supply shocks, inflation did fall a lot. The 1982 recession is one example.
Those two things I was wrong on are related. It's pretty much the same mistake. I thought you would only get a deficient-demand recession if the Bank of Canada got it wrong and let inflation fall below target; and if you did get a deficient demand recession then inflation would fall below target.
Why didn't that happen like it was supposed to?
One possible answer is that inflation targeting made inflation stickier than it used to be. Which means that inflation targeting became a victim of its own success. By making inflation sticky at 2%, it destroyed the very signal of deficient-demand recessions that monetary policy was supposed to respond to. The thermostat destroyed its own negative feedback mechanism.
You can't test that hypothesis just by looking at inflation data. For example, the Canadian Phillips Curve does look a lot flatter over the last 20 years of inflation targeting than it used to. But of course it does. The whole point of inflation targeting means the Bank of Canada does its best to keep inflation at 2%. So if you put inflation on the vertical axis, and anything else whatsoever on the horizontal axis, the Bank of Canada is trying to make that curve look perfectly flat. Any lack of flatness reflects only the Bank of Canada's mistakes. During the Gold Standard, the price of gold never changed. That doesn't mean the price of gold was sticky.
So I can't prove that inflation targeting made inflation stickier just by looking at the Phillips Curve and saying how much flatter it has become in the last 20 years. But it might still be right. There might have been negative supply shocks that caused the downward-sloping Phillips Curve to shift up during the recent recession, to make it look flat when we plot the data. But I don't think there were, at least not big enough ones to matter much. Gasoline prices went up a bit, but they are stripped out of core inflation, and core inflation looks flat too.
Imagine some sort of simultaneous-moves Nash game, which is partly an American Beauty Contest. Each individual player has to pick a number. He is trying to pick a number that is the same as the average number picked by all the other players, plus or minus some amount that reflects a shock specific to him. He knows that all the other players are trying to do the same. He knows his own shock. He does not know the other players' shocks. He does not even know whether the distribution of the shocks is mean zero. Even if he did know the distribution of the shocks, and could himself solve for the Nash equilibrium, he doesn't know whether the other players can solve for the Nash equilibrium. He strongly suspects that some of them don't have a clue what "Nash equilibrium" even means, or have some other theory of games. He maybe just shrugs his shoulders, and just does what he did last time he played the game, plus or minus his own individual-specific shock.
Unless somebody stands up in the middle of the room and loudly calls out "2%! I want you all to choose 2%!". It would be very tempting just to give up on all the Nash stuff, ignore the shocks, and just choose 2%.
I know. That's not a model. It's not even a fully-coherent story.
But that's one of the things blogs are good for.