If Only Bernanke Had Volcker's FOMC

Former FOMC president Volcker, like Bernanke, is overly reliant on  the creditism view of monetary policy.  Take this past week's comments at the Atlantic magazine news conference.

Higher inflation would backfire by causing interest rates to rise. "You are not going to get any stimulus and you are going to make it much harder to restore price stability,"

Volcker is implying that the higher interest rates that would accompany a higher inflation target would be contractionary.   At first glance, his analysis appears correct, a higher interest rate would seem to suppress already weak aggregate demand.  Yet with today's current low levels of inflation and interest rates at their lower bound, a higher interest rate stemming from a higher inflation target would be a by product of an improved economic outlook.  To understand why this counter intuitive conclusion is correct, we need to look at David Glasner's recent research on deflationary expectations at the zero lower bound, my bold:

 If so, the expressed rationale for the Fed’s quantitative easing policy (Bernanke 2010), namely to reduce long term interest rates, thereby stimulating spending on investment and consumption, reflects a misapprehension of the mechanism by which the policy would be most likely to operate, increasing expectations of both inflation and future profitability and, hence, of the cash flows derived from real assets, causing asset values to rise in step with both inflation expectations and real interest rates. Rather than a policy to reduce interest rates, quantitative easing appears to be a policy for increasing interest rates, though only as a consequence of increasing expected future prices and cash flows.

Once again, the interest rate is not the only transmission mechanism for monetary policy.  Increasing future nominal expectations stimulates the economy at the zero lower bound (regardless of debt levels) by reducing the return on holding cash while simultaneously increasing the future expected nominal income levels for the participants in the economy.  The result is a bidding up of asset prices, increased purchases of all types of goods, which leads to more production and increased demand.   As nominal growth returns to a more normal level, so do interest rates.  Thus, a rise in the interest rate is precisely the result of an improved economic outlook and should be embraced and not shunned by Volcker.

Volcker should heed the advice of his own FOMC who understood perfectly the best way to get out of a recession, this is from the December 1982 meeting minutes:

Mr. Morris: ....I think we  need  a proxy--an independent  intermediate  target--for nominal  GNP,  or  the  closest  thing we  can come  to  as  a  proxy  for nominal  GNP, because  that's what the  name of  the  game  is  supposed  to be.

And sure enough, NGDP grew by upwards of 12 percent year over year in 1983-84, leading to a robust and stable recovery that gave way to the great moderation.  Regrettably,  Volcker appears to be stuck in a communication strategy that uses interest rates as the primary mechanism for the transmission mechanism for monetary policy.  In effect, he is learning to speak Bernakian.