Mankiw on "Divine Coincidence" in Monetary Policy

N. Gregory Mankiw, former Chair of the president’s Council of Economic Advisers, evaluates Robert Hall’s comments at the Kansas City Fed’s Jackson Hole Conference regarding the use of gap measures to guide monetary policy.  Hall argued against the use of such measures and, more fundamentally, against the theoretical existence of natural rate measures that are the basis for calculating the gap. Mankiw also explains why pure inflation targeting, which overcomes some of the problems Hall identifies, is consistent with output and employment stabilization when there is what Olivier Blanchard calls “divine coincidence.”  In the end, however, Mankiw is not convinced that divine coincidence exists:

Comments on “Separating the Business Cycle from Other Economic Fluctuations,” by Robert E. Hall, N. Gregory Mankiw, Jackson Hole Conference, August 2005: In most academic studies of optimal monetary policy, a central bank is assumed to have two main objectives. ... keeping inflation low and stable ... [and] ... keeping the economy’s output of goods and services close to its potential—or, equivalently, keeping unemployment close to its natural rate. ... Optimal policy ... often takes the form of a Taylor rule. The central bank is supposed to set the short-term interest rate as a function of inflation and the deviation of output from potential. Bob Hall’s paper takes aim at the practical application of this framework. He argues for three related but distinct propositions.

First, he claims that it is difficult to estimate potential output, especially contemporaneously. Second, he argues that potential output exhibits substantial high-frequency variation, so the normal presumption that it follows a smooth trend is suspect. Third, he suggests that modern theories of the labor market call into question the very concept of the natural rate of unemployment and thus potential output. The bottom line from these arguments is that central bankers should be wary when their staff of economists produces estimates of potential output and the output gap and that they should avoid relying on these estimates when setting monetary policy. The alternative is to focus almost exclusively on the other variable in their objective function—the rate of inflation.

I agree with Bob’s first argument completely. The natural rate of unemployment and potential output are extraordinarily difficult to estimate. ... This means that central bankers should be suspicious of any estimate of the natural rate. ... Bob’s second claim is that potential output exhibits significant high-frequency variation. I find this conclusion less compelling. ... I am not suggesting that I know that potential output follows a smooth trend, as is so often assumed. ... But I don’t think the kind of calculations presented in this paper shed much light on how substantial the year-to-year fluctuations in potential output really are.

The third line of argument that Bob pursues in this paper is the suggestion that the whole distinction between the natural rate of unemployment and cyclical unemployment is misguided. From my perspective, this part of the paper is half-baked. This is not to say that the argument is wrong, only that it is insufficiently developed to evaluate it with much confidence. ... In the end, I agree with Bob that monetary policymakers should take estimates of potential output and the natural rate of unemployment with more than a grain of salt. But I am disinclined to sign on to his suggestion that we reject the textbook approach to economic fluctuations...

This brings me to the policy question: If we cannot estimate potential output or the natural rate of unemployment, what are monetary policymakers to do? The obvious alternative is to focus exclusively on inflation, as some inflation-targeting central banks are now doing. Such a regime of pure inflation targeting would seem to be inconsistent with the Fed’s dual mandate of being concerned about both price stability and full employment. ... however, that this is not necessarily the case. In some modern theories of the business cycle, a monetary policy that aimed exclusively at stabilizing the price level would achieve, as a by-product, stabilization of output at its potential level. Olivier Blanchard has called this fact the “divine coincidence.” If the divine coincidence is actually true, it would conveniently solve the conundrum raised in this paper, for the central bank would not need to measure potential output in order to keep actual output at potential. It would only need to stabilize prices.

Let me spend a few minutes explaining why the divine coincidence might be true. Consider first shocks to the aggregate demand for goods and services. Expansionary demand shocks tend to push prices up and output above potential; contractionary demand shocks put downward pressure on prices and depress output below potential. Because the price level and the output gap are moving in the same direction, a monetary policy that stabilizes one will automatically stabilizes the other. In other words, a central bank that follows a policy of pure inflation targeting will, as a desirable side effect, insulate output from shocks to aggregate demand.

Now consider shocks to productivity. A positive shock to productivity ... puts downward pressure on prices and tends to increase output. A central bank committed to pure inflation targeting would respond with more expansionary policy, increasing output further. ... [R]emember that the positive productivity shock also raises potential output. In many standard models, these two effects exactly balance. ... if the central bank keeps the price level on target, output and potential output will increase by exactly the same amount in response to a positive productivity shock. Once again, stabilizing prices automatically stabilizes output at potential. You can now see why Blanchard calls this the divine coincidence.

Is this coincidence true in the world, or just an artifact of some oversimplified macroeconomic theories? The literature on this topic not sufficiently developed to give a definitive answer, but my guess is that it is more likely an artifact... [If] supply shocks are not simply shifts in productivity but also represent shifts in how distorted the economy’s production process is ... then it turns out that the divine coincidence does not arise. In this case, monetary policymakers face a trade-off between stabilizing inflation and stabilizing the output gap. Whether this kind of supply shock is an important feature of the world is, I believe, a crucial unanswered question.

So what does all this mean for the practice of central banking? Unlike Bob, I am not ready to give up on concepts such as potential output and the natural rate of unemployment. But I agree with him that we measure these concepts poorly and that this fact suggests increased emphasis on measures of inflation. Some might argue for an exclusive focus on inflation, but I don’t see the current state of monetary theory as necessarily supporting such an extreme view. In the end, central bankers have little choice but to look at all the data, apply a healthy dose of skepticism, and muddle through.