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Wednesday, June 29, 2005

WSJ Commentary: Monetary Policy Does Not Affect Core Inflation

The Wall Street Journal can do better than this.  This article by Alan Reynolds of Cato claims that monetary policy has no effect on prices and inflation, a claim that is just plain dumb:

The Fed's Crude Policy, By Alan Reynolds, The Wall Street Journal (subscription):  … It is commonly assumed that the Fed "leans against" inflation -- raising interest rates when inflation accelerates and lowering rates when inflation slows. Yet the graph nearby (free) proves it is difficult to discover any coherent relationship between the funds rate and the "core" deflator for personal consumption expenditures (PCE), or any other measure of inflation not distorted by energy prices. … The only way to link the fed-funds rate to inflation is to assume the Fed suffered from "energy illusion" -- focusing on fluctuating energy prices rather than the impressive stability of other consumer prices. Perhaps the best way to show this is to look at the consumer price index with and without energy, so there can be no doubt that food prices (which are also excluded from core inflation) were irrelevant…

Here’s the problem with this "analysis."  Suppose that monetary policy perfectly controlled inflation.  What would a graph of inflation over time look like (note that the author only shows a few years in the graph)?  It would be a flat line with no variation from its target value whatsoever, and it would be uncorrelated with any other variable.  The fact that there is no correlation between inflation and the ff rate would be an indication of the success of the policy, not that inflation and monetary policy are unrelated.  Looking at such raw correlations tells us nothing at all about causal relationships.  This is a very well known fallacy in the literature surrounding monetary policy and anyone who purports to write as an expert on monetary policy ought to be aware of this.

As for the other part of the argument, there are sound theoretical reasons for looking at core inflation rather than total inflation that I won’t detail here.  But suppose that core inflation is the target of monetary policy.  Then core inflation would flat line but total inflation would not, and a measure of inflation including energy prices could show a correlation with the ff rate as claimed in the article.

But the conclusion is exactly the opposite of what the author claims.  Finding a correlation between the ff rate and inflation including energy prices means, if policy is successful, that policy does not target energy prices, not that it does.

Monetary policy does not affect prices and inflation?  This does not belong in the Wall Street Journal.

    Posted by on Wednesday, June 29, 2005 at 09:37 AM in Economics, Monetary Policy, Press | Permalink  TrackBack (1)  Comments (8)

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    Tracked on Thursday, June 30, 2005 at 11:31 AM


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