Category Archive for: Inflation [Return to Main]

Thursday, October 08, 2015

'The Slow Rate of Labor Market Improvement in 2015 is Not All That Surprising'

Federal Reserve Bank of Minneapolis president Narayana Kocherlakota:

...Why has the rate of labor market improvement slowed so much in 2015 relative to 2014? In thinking about this question, I find the timing of monetary policy changes to be highly suggestive.
In mid-2013, the FOMC announced its intention to taper its ongoing asset purchase program. We can see that this announcement represented a dramatic change in policy from the sharp upward movements in long-term bond yields that it engendered. Personally, I interpret this policy change back in 2013 as the onset of what the Committee currently intends to be a long, gradual tightening cycle. As I noted earlier, we would typically expect that such a change in monetary policy should affect the economy with a lag of about 18 to 24 months. Viewed through this lens, the slow rate of labor market improvement in 2015 is not all that surprising.
I believe the FOMC should take actions to facilitate a resumption of the 2014 improvement in the labor market by adopting a more accommodative policy stance. Remember, inflation is low, and is expected to remain low, relative to the FOMC’s target. In particular, I don’t see raising the target range for the fed funds rate above its current low level in 2015 or 2016 as being consistent with the pursuit of the kind of labor market outcomes that we are charged with delivering. Indeed, I would be open to the possibility of reducing the fed funds target funds range even further, as a way of producing better labor market outcomes.
There is, of course, a risk that inflationary pressures could build up more rapidly than I (or others) currently anticipate. But the solution to this scenario is relatively simple: Raise interest rates. Given my current outlook, I believe that it would be appropriate to wait until 2017 to initiate liftoff and then raise the fed funds rate at about 2 percentage points per year. My preferred pace of tightening mirrors the pace of tightening from 2004 to 2006—a pace of tightening that is often seen as gradual. (In fact, some would argue, with the benefit of hindsight, that it was overly gradual.) In response to unanticipated inflationary pressures, the FOMC could simply react as it did in 1994, and raise the fed funds rate more rapidly than this gradual pace.
... The lesson of 2014 is clear: We can do better. Given 2014, and given how low inflation is expected to be over the next few years, I see no reason why the Committee should not aim to facilitate continued improvement in labor market conditions. Indeed, I currently see no reason why we should not aim for the kind of strong labor market conditions that prevailed at the end of 2006.
But we will get there only if we make the right choices. The FOMC can achieve its congressionally mandated price and employment goals only by being extraordinarily patient in reducing the level of monetary accommodation. Indeed, to best fulfill its congressional mandates, the Committee should be considering reducing the target range for the fed funds rate, not increasing it. ...

Saturday, September 26, 2015

'Economics: What Went Right'

Paul Krugman returns to a familiar theme:

Economics: What Went Right: ...I’m at EconEd; here are my slides for later today. The theme of my talk is something I’ve emphasized a lot over the past few years: basic macroeconomics has actually worked remarkably well in the post-crisis world, with those of us who took our Hicks seriously calling the big stuff — the effects of monetary and fiscal policy — right, and those who went with their gut getting it all wrong. ...
One thing I do try is to concede that one piece of the conventional story hasn’t worked that well, namely the Phillips curve, where the “clockwise spirals” of previous protracted large output gaps haven’t materialized. Maybe it’s about what happens at very low inflation rates.
What’s notable about the Fed’s urge to raise rates, however, is that Fed officials, including Janet Yellen, are acting as if they have high confidence in their models of inflation dynamics –which is the one thing we really haven’t done well at recently. I really fear that we’re looking at incestuous amplification here.

Agree about the uncertainty about inflation dynamics, but fear Fed officials will interpret it as risks on the upside that must be nullified through interest rate hikes. As for the Phillips curve, here's a graph from his talk:


As Krugman says, "Maybe it’s about what happens at very low inflation rates." I would add that the combination of the zero bound, low inflation, and downward wage rigidity may be able to explain the change in the Phillips curve -- I'm not quite ready to give up yet.

More generally, estimating inflation dynamics has been far from successful. For example, in many VAR models (a widely used empirical specification for establishing relationships among macroeconomic series), a shock to the federal funds rate often causes prices to go up (theory says they should go down). This can be overcome somewhat by including commodity prices in the model. The idea is that when the Fed expects inflation to go up it raises the federal funds rate, and since the policy does not complete eliminate the inflation, the data will show a positive correlation between the federal funds rate and inflation. Commodity prices are thought to embody and be sensitive to future expected inflation, so including this variable helps to solve the "price puzzle" as it is known. Even so, the results are highly sensitive to specification, and when you work with these models regularly you come away believing that the estimated price dynamics are not very good at all.

But the Fed must forecast in order to do policy. There are lags (though I've argued they are likely shorter than common wisdom suggests), and the Fed must act before a clear picture emerges. The question is how the Fed should react to such uncertainty about its inflation forecasts, and to me -- given the corresponding uncertainties about the state of the labor market and the asymmetric nature of the costs of mistakes about inflation and unemployment (plus the distributional issues -- who gets hurt by each mistake?), it counsels patience rather than urgency on the inflation front.

Monday, September 21, 2015

'Can We Rely on Market-Based Inflation Forecasts?'

Michael Bauer and Erin McCarthy of the SF Fed:

Can We Rely on Market-Based Inflation Forecasts?, Michael D. Bauer and Erin McCarthy, Economic Letter, FRBSF: The Federal Reserve’s dual mandate requires monetary policy to aim for both maximum employment and price stability. Although employment has recovered since the recession, inflation has consistently remained below the Fed’s 2% longer-run objective. Because expectations of future inflation play an important role in determining current inflation, decreases in measures of inflation expectations based on market prices have raised some concerns. For example, between June 2014 and January 2015, one-year inflation swap rates, which measure market-based expectations of inflation in the consumer price index (CPI) one year ahead, dropped over 2.5 percentage points. Large decreases were also observed in breakeven inflation rates, the difference between yields on nominal and inflation-indexed Treasury securities, known as TIPS.
Market-based measures of inflation expectations are calculated from the prices of financial securities. Their advantage is that they are readily available at high frequency and therefore are widely monitored. However, they reflect not only the public’s inflation expectations but also other idiosyncratic factors that affect market prices, which are difficult to quantify. For example, they include a risk premium to compensate investors for inflation uncertainty and are affected by changes in liquidity, unusual demand flows, and, more broadly, “animal spirits” that change prices but are unrelated to expectations (see Bauer and Rudebusch 2015). Hence it is unclear how much useful information they provide, and how much one should pay attention to these rates when forecasting inflation.
If market-based inflation expectations provided accurate inflation forecasts, then one surely would want to pay close attention to their evolution. In this Economic Letter, we evaluate their performance in comparison with a variety of alternative forecasts for CPI inflation. ...
Conclusions We find that market-based measures of inflation are poor predictors of future inflation. In particular, they perform much worse than forecasts constructed from survey expectations of future inflation, which incorporate all the information used by professional forecasters. Interestingly, a simple constant inflation rate corresponding to the Federal Reserve’s 2% inflation target consistently performs best. While our analysis is based on a short sample that displays a lot of volatility during the Great Recession, our results appear quite robust as they are consistent across two subsamples.
Our results add to the discussion about how much attention policymakers and professional forecasters should pay to market-based inflation forecasts. These measures mostly reflect current and past inflation movements, and do not contain a lot of useful forward-looking information. Idiosyncratic market forces and inflation risk premiums appear to be important drivers of market-based inflation expectations. Overall, it is important to keep this caveat in mind when interpreting market-based inflation expectations.

Friday, September 11, 2015

Paul Krugman: Japan’s Economy, Crippled by Caution

Ending deflation is easy. But convincing people to support the policy that is needed is almost impossible:

Japan’s Economy, Crippled by Caution, by Paul Krugman, Commentary, NY Times: Visitors to Japan are often surprised by how prosperous it seems. It doesn’t look like a deeply depressed economy. And that’s because it isn’t. ...
Yet Japan is still caught in an economic trap. Persistent deflation... So Japan needs to make a decisive break with its deflationary past. You might think ... ending deflation is easy. Can’t you just print money? But ... central banks like the Federal Reserve or the Bank of Japan ... generally use it to buy government debt. In normal times ... sellers of that government debt don’t want to sit on idle cash, so they lend it out, stimulating spending... And as the economy heats up, wages and prices should eventually start to rise, solving the problem of deflation.
These days, however, interest rates are very low in most major economies, reflecting the weakness of investment demand. What this means is that there’s no real penalty for sitting on cash, and that’s what people and institutions do. ...
How, then, can policy fight deflation?
Well, the answer currently being tried in much of the world is so-called quantitative easing. ... But is this sufficient? Doubtful. ...
What’s remarkable about this record of dubious achievement is that there actually is a surefire way to fight deflation: When you print money, don’t use it to buy assets; use it to buy stuff. That is, run budget deficits paid for with the printing press. ...
But nobody is doing the obvious thing. Instead, all around the advanced world governments are engaged in fiscal austerity, dragging their economies down...
Why? Part of the answer is that demands for austerity serve a political agenda, with panic over the alleged risks of deficits providing an excuse for cuts in social spending. But the biggest reason it’s so hard to fight deflation, I contend, is the curse of conventionality.
After all, printing money to pay for stuff sounds irresponsible, because in normal times it is. And no matter how many times some of us try to explain that these are not normal times, that in a depressed, deflationary economy conventional fiscal prudence is dangerous folly, very few policy makers are willing to stick their necks out and break with convention.
The result is that seven years after the financial crisis, policy is still crippled by caution. Respectability is killing the world economy.

Wednesday, September 09, 2015

The Fed Must Act Soon? Why?

I tried to argue against the points Richard Fisher is making in my column yesterday.

First, he tells us to ignore the headline inflation rate since it is subject to lots of short-run variation from factors such as food and commodity prices, and instead focus on the Dallas Fed's trimmed mean measure. Here it is:

12-month PCE inflation
  Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15
PCE excluding food & energy
Trimmed Mean PCE

See the problem? The Fed's target rte of inflation is 2.0 percent, but trimmed mean inflation, which is intended to isolate long-run inflation trends and ignore short-run variation, is holding steady at 1.6 percent.

Actually, Fisher is a bit loose with the numbers. He says:

conventional core PCE inflation has averaged 1.65 per cent, nearly 30 basis points below headline inflation’s 1.94 per cent average.

But, his preferred measure of inflation, the trimmed mean, shows inflation:

coming in at 1.83 per cent over the past decade, 10 basis points below the headline rate.

But for policy, who cares about 10 years ago? Recently, as shown above, the measure has been close to 1.6 percent, and that's a big miss on the downward side. He does acknowledge this, but still acts as though it is only a near miss:

the Dallas Fed trimmed mean rate has been running steadily at 1.6 per cent over the past year, lower than policymakers are shooting for, but less discouraging than the most watched measures suggest.

Yes, 1.6 versus 1.2 percent for July (see above) is a bit better, but let's not pretend it's close to target. Maybe it is "less discouraging," but it is still discouraging.

In any case, if you are a hawk and want rates up, what do you argue at this point? First, that labor markets are tightening (he ignores the secular stagnation point others use to argue labor markets are tighter than they seem), and inflation is just around the corner (as it always is if you are Richard Fisher, go back and look at what he has been saying throughout the crisis -- inflation has always been just ahead):

History tells us that wage growth initially picks up slowly when unemployment starts to fall but, as it approaches more fulsome levels, wage rises accelerate.
That is the territory we are approaching now. Unemployment has reached 5.1 per cent sooner than the Fed’s rate setters expected. Wage-inflation pressures are not yet nettlesome but they have been rising, smack dab in line with past experience.

But as I explained in my column, recent research says much of that history can be ignored since the relationship between wage inflation and price inflation has changed considerably over the years (pass-through has diminished quite a bit since 1980, i.e. wage increases no longer translate into price increases as they once did, for example in the 1970s Fisher remembers so well). And as the WSJ recently explained, where is the wage inflation the hawks are so worried about?:

U.S. employers aren’t yet being squeezed by workers demanding higher wages. The employment-cost index, a broad gauge of wage and benefit expenditures, rose a seasonally adjusted 0.6% in the fourth quarter last year, the Labor Department said Friday. That’s down from 0.7% in the two earlier quarters and jibes with other data showing only limited wage pressure across the U.S. 

But inflation is coming. It's always coming, right?

Okay, price inflation is below target, wage inflation is really hard to find, and there are many reasons to suspect that labor markets are not as robust as the unemployment rate suggests (not to mention uncertainties in the world economy). But if you are a hawk, you don't give up merely because the data is stacked against you. Instead, you fall back on the "long lags" argument:

Monetary policy ... operates with a lag. If the Fed waits for full employment and then has to throttle back sharply, there will be a nasty shock. The upcoming Fed meetings present a timely opportunity to start slowing down the engines

The question I raised yesterday is whether, with advances in digital technology, we should expect these lags to be as long as they were in the past, e.g. in the 1970s. It seems to me that they have likely shortened, perhaps quite a bit, and that gives the Fed more room for patience than it had in the past. Couldn't it at least wait for clear signs of a problem before acting?

Finally, why the huge fear over a little bit of inflation rather than huge fear over higher than necessary unemployment? Why not reserve the same level of fear for those who struggle with unemployment and all the troubles that come with it? Which is the greater problem to avoid? If we make a mistake, should it be to allow a bit of inflation, which the Fed can quickly reverse, or allow a higher level of unemployment, a problem that is much more costly and much harder to deal with? Why does inflation get so much more attention from some people? Why the hurry to raise rates?

Tuesday, September 08, 2015

The Fed Must Banish the 1970’s Inflation Devil

I have a new column:

The Fed Must Banish the 1970’s Inflation Devil: Will the Fed raise rates when it meets later this month? Inflation remains below the Fed’s two percent target, and that argues against a rate increase. But labor markets appear to be tightening and that is raising worries that higher inflation is just ahead. Should the Fed launch a preemptive strike against the possibility of wage-fueled inflationary pressure? ...

Hopefully there's at least one argument against raising rates that you have not heard before.

Saturday, September 05, 2015

Deflation and Money

The summary "Deflation and money" by Hiroshi Yoshikawa, Hideaki Aoyama, Yoshi Fujiwara, and Hiroshi Iyetomiof says:

Deflation and money, Vox EU: Deflation is a threat to the macroeconomy. Japan had suffered from deflation for more than a decade, and now, Europe is facing it. To combat deflation under the zero interest bound, the Bank of Japan and the European Central Bank have resorted to quantitative easing, or increasing the money supply. This column explores its effectiveness, through the application of novel methods to distinguish signals from noises.

The conclusion:

...all in all, the results we obtained have confirmed that aggregate prices significantly change, either upward or downward, as the level of real output changes. The correlation between aggregate prices and money, on the other hand, is not significant. The major factors affecting aggregate prices other than the level of real economic activity are the exchange rate and the prices of raw materials represented by the price of oil. Japan suffered from deflation for more than a decade beginning at the end of the last century. More recently, Europe faces a threat of deflation. Our analysis suggests that it is difficult to combat deflation only by expanding the money supply.

Tuesday, July 28, 2015

'Are We Overestimating Inflation (Again?)'

Cecchetti & Schoenholtz:

Are we overestimating inflation (again?): Twenty years ago, a group of experts – the “Boskin Commission” – concluded that the U.S. consumer price index (CPI) systematically overstated inflation by 0.8 to 1.6 percentage points each year. Taking these findings to heart, the Bureau of Labor Statistics (BLS) got to work reducing this bias, so that by the mid-2000s, experts felt it had fallen by as much as half a percentage point.
We bring this up because there is a concern that as a consequence of the way in which we measure information technology (IT), health care, digital content and the like, the degree to which conventional indices overestimate inflation may have risen. ...
When indices like the consumer price index (CPI) or the personal consumption expenditure price index (PCE) persistently overstate inflation, there are important consequences. So long as the upward bias is constant, central bankers can (and do) modify their inflation targets. Yet, these price indexes also are used to adjust entitlement benefits without correcting for any persistent bias. And, they can have an important impact on public discourse. In particular, upward bias means that the median real wage may have risen substantially over past decades, in contrast to reported stagnation.
If the overstatement of inflation has increased during the past decade, this also has profound consequences. For one thing, the reported slowdown in annual productivity growth – from something like 2½% in the decade prior to the crisis to about 1% today – could be more apparent than real. For another, true inflation may be even further below the Federal Reserve’s long-run objective of 2% on the PCE than current readings imply.
There is good reason to think that the price mismeasurement problem has gotten worse, but quantifying that deterioration is another thing. The impact on inflation may turn out to be small – perhaps an extra ¼% annually – leaving it well within the range of uncertainty that the Boskin Commission highlighted 20 years ago. ...

After presenting their analysis, they end with:

So, what’s the bottom line? We have little doubt that inflation has been overstated for decades. That means that the rise of U.S. real output, real income, productivity, and living standards has been understated materially over the long run. In recent years, IT price mismeasurement probably has worsened this growth and productivity bias significantly. But the potential impact of IT mismeasurement on measures of consumer price inflation – which has been the source of much discussion – is small compared to what a worsening bias in health care prices would imply.

[There is a large controversy surrounding the Boskin report that I am ignoring.]

Thursday, June 18, 2015

'Wage Increases Do Not Signal Impending Inflation'

This note from Carola Binder was intended for the Fed meeting earlier this week, but it applies equally well to meetings yet to come:

Wage Increases Do Not Signal Impending Inflation: When the FOMC meets..., they will surely be looking for signs of impending inflation. Even though actual inflation is below target, any hint that pressure is building will be seized upon by more hawkish committee members as impetus for an earlier rate rise. The relatively strong May jobs report and uptick in nominal wage inflation are likely to draw attention in this respect.
Hopefully the FOMC members are aware of new research by two of the Fed's own economists, Ekaterina Peneva and Jeremy Rudd, on the passthrough (or lack thereof) of labor costs to price inflation. The research, which fails to find an important role for labor costs in driving inflation movements, casts doubts on wage-based explanations of inflation dynamics in recent years. They conclude that "price inflation now responds less persistently to changes in real activity or costs; at the same time, the joint dynamics of inflation and compensation no longer manifest the type of wage–price spiral that was evident in earlier decades." ...

Thursday, June 04, 2015

'The Gap between Services Inflation and Goods Inflation'


[More on this at the Cleveland Fed]

Tuesday, May 05, 2015

'Inflation Expectations and Recovery from the Depression in 1933'

Andrew Jalil and Gisela Rua:

Inflation Expectations and Recovery from the Depression in 1933: Evidence from the Narrative Record, by Andrew Jalil and Gisela Rua, April 2015: Abstract This paper uses the historical narrative record to determine whether inflation expectations shifted during the second quarter of 1933, precisely as the recovery from the Great Depression took hold. First, by examining the historical news record and the forecasts of contemporary business analysts, we show that inflation expectations increased dramatically. Second, using an event - studies approach, we identify the impact on financial markets of the key events that shifted inflation expectations. Third, we gather new evidence — both quantitative and narrative — that indicates that the shift in inflation expectations played a causal role in stimulating the recovery.

Thursday, April 02, 2015

'Central Bank Solvency and Inflation'

Marco Del Negro and Christopher A. Sims:

Central Bank Solvency and Inflation, Liberty Street Economics: The monetary base in the United States, defined as currency plus bank reserves, grew from about $800 billion in 2008 to $2 trillion in 2012, and to roughly $4 trillion at the end of 2014 (see chart below). Some commentators have viewed this increase in the monetary base as a sure harbinger of inflation. For example, one economist wrote that this “unprecedented expansion of the money supply could make the '70s look benign.” These predictions of inflation rest on the monetarist argument that nominal income is proportional to the money supply. The fact that the money supply has expanded rapidly while real income has grown very modestly means that sooner or later prices will have to catch up. Most academic economists (from Cochrane to Krugman and Mankiw) disagree. The monetarist argument arguably applies only to non-interest-bearing central bank liabilities, but since October 2008 a large fraction of the monetary base has consisted of reserves that pay interest (the so-called IOER, or interest on excess reserves) and one linchpin of the Fed’s “policy normalization principles” consists precisely in raising the IOER along with the federal funds rate. Since reserves pay close to market interest rates, they are close substitutes for other short-term assets such as Treasury bills from a bank’s perspective. As long as the central bank can affect the return on these short-term assets by adjusting the IOER, controlling inflation with a large balance sheet seems no different than it was before the Great Recession.

U.S. Monetar Base

In fact, if we look at expansion of the central bank’s balance sheet (known as LSAP—large-scale asset purchases—within the Fed, and as QE—quantitative easing—to the rest of the world) from the perspective of the consolidated budget constraint of the U.S. government, we realize that the expansion shortened the maturity structure of the federal debt (at least for the part concerning the purchase of Treasuries), as explained in the LSE post “More Than Meets the Eye: Some Fiscal Implications of Monetary Policy.” When the Fed buys long-term Treasuries by issuing interest-bearing reserves, it effectively retires this long-term debt, at least temporarily, and replaces it with very short-term (overnight) debt reserves. Seen from this vantage point, the hyperinflation fears mentioned above appear misplaced: Why should a change in the maturity structure of the federal debt generate hyperinflation as long as the central bank continues to follow a Taylor-type rule for setting interest rates?
In our staff report “When Does a Central Bank’s Balance Sheet Require Fiscal Support?” we show that there is a potentially big difference between pre- and post-Great Recession central banking. We argue that a large, long-duration central bank balance sheet can, at least in principle, impair a central bank’s ability to control inflation if the fiscal authority (the Treasury) refuses to back under any circumstances the central bank’s balance sheet.
Our argument is very different from that dismissed at the beginning of this post. It rests on the observation that QE, almost by definition, resulted in a sizable maturity mismatch between the asset and the liability side of the central bank’s balance sheet. Many recent papers (for example, Hall and Reis; Carpenter et al.; Greenlaw, Hamilton, Hooper, and Mishkin; and Christensen, Lopez, and Rudebusch) have noted this mismatch, and have computed the implications of different interest rate renormalization paths for remittances from the central bank to the Treasury. Relative to these papers, we explicitly model the fact that seigniorage—revenues arising from currency creation—depends on the path of inflation and interest rates. We show that this endogeneity opens the door to the possibility of multiple equilibria in the absence of fiscal support.
Imagine that you are a Treasury investor and you know that the only resource the central bank can rely upon is seigniorage. You also know that the value of the central bank’s assets (long-term bonds) would fall below that of the bank’s interest-bearing liabilities (reserves, which are short-term) if high inflation and interest rates were to occur in the near future. Then you put two and two together and figure out that expectations of high inflation would actually force the central bank to rely on seigniorage, thereby validating such expectations. If you can convince your fellow investors that these expectations are to materialize, then your projection can become a self-fulfilling prophecy, reminiscent of second-generation currency crisis models.
Before we go any further, we should stress that this sort of self-fulfilling prophecy is unlikely to take hold in the United States for two reasons. First, we compute in our simulations that the expected present value of seigniorage for the central bank is very high, roughly the size of current U.S. GDP, under a most likely path for future interest rates. As a consequence, it would take very extreme expectations for interest rates to force the central bank to generate more seigniorage and validate the expectations. Moreover, there are reasons to believe that the assumption of no fiscal support under any circumstances is incorrect: if faced with the prospect of high inflation, the Treasury would eventually be willing to provide support to the central bank. Note that this support comes at no cost at all for the Treasury: simply being willing to provide it is enough to nip any hyperinflation in the bud.
What are the policy implications of all this? Certainly not that the central bank should not have engaged in QE. Much research has shown that QE successfully eased financial conditions, thereby promoting economic recovery. Rather, we argue that it would always be appropriate for a central bank to have access to, and be willing to ask for, support for its balance sheet by the fiscal authority. In other words, central bank independence does not mean that the central bank can control inflation regardless of the actions of the fiscal authority. As shown by history, it never has.
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

Wednesday, March 25, 2015

'Fed Should Push Unemployment Well Below 5%, Paper Says'

Larry Ball tells the Fed to be very patient when it comes to satisfying its mandate to pursue full employment:

Fed Should Push Unemployment Well Below 5%, Paper Says: The Federal Reserve should hold short-term interest rates near zero long enough to drive unemployment well below 5%, even if it means letting inflation exceed the central bank’s 2% target. That’s according to Laurence Ball, economics professor and monetary policy expert at Johns Hopkins University...
Mr. Ball says the Fed could create more jobs by letting the unemployment rate fall lower. It should seek to push the rate “well below 5%, at least temporarily,” he writes. That could help bring some discouraged workers to reenter the labor market, as well as help the long-term unemployed find work and involuntary part-time workers find full-time jobs, he said.
“A likely side effect would be a temporary rise in inflation above the Fed’s target, but that outcome is acceptable,” writes Mr. Ball... U.S. inflation has been undershooting the Fed’s target for nearly three years.
Mr. Ball’s view is not shared by many Fed officials...

Wednesday, March 11, 2015

'Hard Money'

Brad DeLong:

Austerity, Gramscian Hegemony, and Hard Money: To the Re-Education Camp! Weblogging: ... Paul Krugman tries to untangle why so many center-right and right-wing economists are so resistant to the elementary logic of Hicks (1937) and the IS-LM model—even those who, like Marty Feldstein, teach the IS-LM model to their students, and teach it very well (after all: he taught it to me).

Back in 2009 ... Mark Thoma wrote a good piece giving what seemed to me to be the correct answer to the inflationistas: He wrote that there was some reason to fear an outburst of inflation when and if the long run came in which the government budget constraint bound and yet congress was continuing to refuse to either:

  • curb the growth of public health care costs, or
  • raise taxes to pay for them.

But, he went on, the IS-LM logic meant that that was not a risk in the short run. And the cost of the stimulus program and how much debt was "monetized" by QE had at best a second decimal-place effect on the vulnerability of the U.S. to long-run inflation driven by the fiscal theory of the price level. The big enchilada was health-care costs...[quotes my old post]...

That seemed and seems to me to be right, and that is driven by a coherent theoretical view: (i) an unemployment short-run until production returns to potential output, (ii) a medium run in which confidence and interest rates and full-employment growth rates depend on market assessments of how the long-run fiscal gap will be closed, and (iii) a long run in which, perhaps suddenly and unexpectedly, the fiscal theory of the price level binds.

The only thing wrong with Mark's analysis back in 2009 that I saw then and that I see now--other than the short run being a very long time indeed, the bending of the health care costs curve occurring much more sharply than I had imagined possible, and a configuration of interest rates which raises the strong possibility that the long-run in which the fiscal theory of the price level binds has been put off to infinity--was that it missed the easiest way of shrinking the velocity of money in a recovery: raising reserve requirements. So I always had a very hard time figuring out what Feldstein and company were fearing at all...

Indeed, it seemed to me not to be coherent:

 Martin Feldstein: "The unprecedented explosion of the US fiscal deficit raises the spectre of high future inflation. ... It is surprising that the long-term interest rates do not yet reflect the resulting risk of future inflation...

... As I looked back on the situation in 2009 and 2010--with a dead housing credit channel, and the increasing likelihood of a recovery characterized not as a V or as a U but as an L--I find myself thinking that Marty Feldstein and the others had turned all their smarts to trying to find reasons not to believe the IS-LM models that they (or at least Feldstein and Taylor) had taught, and not to believe that the marginal investor in financial markets was not-stupid. That fiscal and monetary ease would bring back the 1970s in short order was their conclusion. The task was to think of not-implausible reasons and mechanisms that would make this so.

The corollary, of course, is that for them the only good policies are hard-money austerity policies; and the only good portfolios are those that assume a departure from hard-money austerity will produce inflation.

So perhaps there is a deeper problem somewhere..., it really makes no sense for my contemporaries to be hard-money believers. Yet an astonishing share of the rich among them are.

A great and enduring puzzle...

So: To the re-education camp! I have a lot of rethinking to do--but not about IS-LM, hysteresis, or the fiscal theory of the price level; rather, about the connecting-belts between asset values, wealth levels, and people's ideal interests of what proper monetary and fiscal policy should be.

Monday, February 02, 2015

Fed Watch: Fed's Preferred Inflation Measure Dives

Tim Duy:

Fed's Preferred Inflation Measure Dives, by Tim Duy: Not only is core-PCE inflation on a year-over-year basis trending away from the Fed's target:


but the deceleration in recent months is truly shocking:


It is hard to see how the Fed can be confident that inflation with trend back to target when looking at these numbers. They need some acceleration in wage growth to justify their intentions to begin normalizing policy, and even with such acceleration, I think their case is fairly weak in the context of the current inflation environment. If they make a case, they will base it on these three pillars:

1.) With unemployment nearing 5%, they have reached their employment mandate.
2.) Monetary policy is exceptionally accommodative even if they raise interest rates.
3.) Failure to raise rates invites asset bubbles.

On point three, refer to New York Federal Reserve President William Dudley:

Quickly, let me give two examples that illustrate how variable this linkage can be.  First, during the 2004-07 period, the FOMC tightened monetary policy nearly continuously, raising the federal funds rate from 1 percent to 5.25 percent in 17 steps.  However, during this period, 10-year Treasury note yields did not rise much, credit spreads generally narrowed and U.S. equity price indices moved higher.  Moreover, the availability of mortgage credit eased, rather than tightened.  As a result, financial market conditions did not tighten.  

As a result, financial conditions remained quite loose, despite the large increase in the federal funds rate.  With the benefit of hindsight, it seems that either monetary policy should have been tightened more aggressively or macroprudential measures should have been implemented in order to tighten credit conditions in the overheated housing sector.

It may be that the Fed looks at the tech and housing bubble episodes and concludes that zero interest rates are not desirable even if inflation is below trend. Yes, I know, macroprudential before interest rates when addressing asset bubbles. But at a point when the economy is at the Fed's idea of full-employment, and given the events of recent decades? Easy to see the Fed seeing danger in putting all of their eggs in the macroprudential basket. 

Bottom Line: Below trend inflation as the economy nears full-employment is a very uncomfortable position for the Federal Reserve. It will be interesting to see how Federal Reserve Chair Janet Yellen navigates these waters at the upcoming Congressional testimony.

Monday, January 26, 2015

'Does Monopoly Power Cause Inflation? (1968 and all that)'

Nick Rowe:

Does monopoly power cause inflation? (1968 and all that): Here's a question for you: Suppose there is a permanent increase in monopoly power across the economy (either firms having more monopoly power in output markets, or unions having more monopoly power in labour markets). Would that permanent increase in monopoly power cause a permanent increase in the inflation rate?
Most economists today would answer "no" to that question. It might maybe cause a temporary once-and-for-all rise in the price level, but it would not cause a permanent increase in the inflation rate. The question just sounds strange to modern economists' ears. They would much prefer to discuss whether a permanent increase in monopoly power caused a permanent reduction in real output and employment. What has monopoly power got to do with inflation?
To economists 40 or 50 years ago, the question would not have sounded strange at all. Many (maybe most?) economists would have answered "yes" to that question. ...


Thursday, December 18, 2014

About Those Cost Push Inflation Fears...

Via Real Time Economics at the WSJ:

No Sign Yet of Labor Cost Inflation in U.S. or U.K., by Paul Hannon: Despite falling unemployment rates, there are few signs that rising wages will soon start to push inflation higher in either the U.S. or the U.K., where central banks are expected to raise their benchmark rates next year and in early 2016 respectively.
In both countries, policy makers expect tightening labor markets to result in a pickup in wages that will translate into higher consumer prices, as businesses act to protect their profit margins...
But an internationally comparable measure of labor costs released Thursday by the Organization for Economic Cooperation and Development showed no sign of a buildup in inflationary pressures from that source in either country.
Indeed, the Paris-based research body recorded a 0.1% drop in unit labor costs in the U.S. during the third quarter, which followed a 0.6% decline in the second quarter. ...

Tuesday, December 09, 2014

'Profiles in Coreage'

Paul Krugman follows up on one of Tim Duy's posts:

Profiles in Coreage: Tim Duy, in the course of a discussion of the outlook for Fed policy, reminds us of the spring of 2011, when headline inflation had risen a lot mainly due to oil prices. He portrays Ben Bernanke as being all alone in insisting that the inflation bump was a blip, and would soon fade away. Actually, that’s not quite right; as far as I recall, most saltwater economists agreed. I was writing about it often. And the Fed, after all, routinely focuses on core inflation rather than headline numbers. Still, Bernanke was definitely under pressure.
What Duy doesn’t say is that the inflation fight of 2011 was about more than inflation; it was another aspect of the fight over how the economy works – and another big victory for the Keynesian view. The concept of core inflation arises out of the notion that most prices are “sticky” ... Standard measures of core inflation are imperfect ways of getting at this distinction, but they ... have been hugely vindicated by the experience of recent years. So I’m glad to see all the people who issued dire warnings about inflation in 2011 acknowledging that they had the wrong model. Hahahahaha.
And yes, this means that you should discount the effects of falling oil prices in the same way you discount the effects of rising oil prices. I would nonetheless urge the Fed to hold off on rate hikes, but for different reasons – the asymmetry in risks between raising rates early and raising them late. And I worry that the Fed may be losing the thread here (hi Stan!). But that’s another topic.

Wednesday, December 03, 2014

'Charles Evans: Low Inflation Is the Primary Concern'

I hope the Fed listens to Charlie Evans (as opposed to Charles Plosser):

Q. and A. With Charles Evans of the Fed: Low Inflation Is the Primary Concern: Charles Evans, president of the Federal Reserve Bank of Chicago, is nervous about inflation. His worry, however, is not the old Fed fear that prices are rising too quickly, but the new Fed fear that prices are not rising fast enough.
Mr. Evans said in an interview Tuesday that he now saw the sluggish pace of inflation as the primary reason the Fed should keep short-term interest rates near zero, a view shared by a growing number of Fed officials.
Mr. Evans, one of the 10 Fed officials who will vote on monetary policy decisions next year, has emerged since the financial crisis as one of the most forceful advocates for the Fed’s stimulus campaign. He pressed successfully in 2012 for more forceful action to reduce unemployment. Now he is warning that the Fed must be careful to avoid raising rates prematurely. ...

Saturday, November 22, 2014

'The Risks to the Inflation Outlook'

Remember all those predictions from those with other agendas about runaway inflation (e.g. see Paul Krugman today on The Wisdom of Peter Schiff)?:

The Risks to the Inflation Outlook, by Vasco Cúrdia, FRBSF Economic Letter: The Federal Reserve responded to the recent financial crisis and the Great Recession by aggressively cutting the target for its benchmark short-term interest rate, known as the federal funds rate, to near zero. The Fed also began providing information about the probable future path of the short-term interest rate. Known as forward guidance, this policy is intended to lead to lower long-term yields and therefore stimulate economic activity. Additionally, the Fed has purchased long-term Treasury securities and mortgage-backed securities, leading to a balance sheet that is substantially larger than before the financial crisis. Taylor (2014), among others, argues that these policies are likely to lead to substantially higher inflation. Nevertheless, the inflation rate remains below 2%, the target set by the Federal Open Market Committee (FOMC).
This Economic Letter describes results from a model that explicitly accounts for the different dimensions of monetary policy to quantify the risks to the inflation forecast. This analysis suggests that inflation is expected to remain low through the end of 2016, and the uncertainty around the forecast is tilted to the downside, that is, the risk of lower inflation. In particular, the probability of low inflation by the end of 2016 is twice as high as the probability of high inflation—the opposite of historical projections. The analysis also suggests that the risk of high inflation collapsed in 2008 and has remained well below normal since. Importantly, according to the model, there is little evidence that monetary policy constitutes a major source of inflation risk. ...

Of course, the lack of inflation can't be explained with modern macroeconomic models:

Inflation Dynamics During the Financial Crisis, by Simon Gilchrist, Raphael Schoenle, W. Sim, and Egon Zakrajsek,  September 18, 2013,  Preliminary & Incomplete: Abstract Using confidential product-level price data underlying the U.S. Producer Price Index (PPI), this paper analyzes the effect of changes in firms’ financial conditions on their price-setting behavior during the “Great Recession.” The evidence indicates that during the height of the crisis in late 2008, firms with “weak” balance sheets increased prices significantly, whereas firms with “strong” balance sheets lowered prices, a response consistent with an adverse demand shock. These stark differences in price-setting behavior are consistent with the notion that financial frictions may significantly influence the response of aggregate inflation to macroeconomic shocks. We explore the implications of these empirical findings within the New Keynesian general equilibrium framework that allows for customer markets and departures from the frictionless financial markets. In the model, firms have an incentive to set a low price to invest in market share, though when financial distortions are severe, firms forgo these investment opportunities and maintain high prices in an effort to preserve their balance-sheet capacity. Consistent with our empirical findings, the model with financial distortions—relative to the baseline model without such distortions—implies a substantial attenuation of price dynamics in response to contractionary demand shocks.

I know, some of you hate old Keynesian models (which can also explain this), and you don't believe in New Keynesian models (ad hoc price stickiness -- reject! -- even if, for some, it is only a cover to reject the notion of government involvement in the economy...). But your model predicted inflation that never came. Or some other such nonsense.

One final note. When I objected to this in 2010, I was called "Grumpy Thoma":

... I think it is quite possible that we will look back on QE2 as a severe error. In spite of the talk from some quarters about the intervention being too small, this is a very large-scale asset purchase for the Fed, on top of a previous very large purchase of mortgage-backed securities and agency securities. One possibility is that economic growth picks up, of its own accord, reserves become less attractive for the banks, and inflation builds up a head of steam. The Fed may find this difficult to control, or may be unwilling to do so. Even worse is the case where growth remains sluggish, but inflation well in excess of 2% starts to rear its ugly head anyway. Bernanke is telling us that he "has the tools to unwind these policies," but if the inflation rate is at 6% and the unemployment rate is still close to 10%, he will not have the stomach to fight the inflation. My concern here is that, given the specifics of the QE2 policy that was announced, the FOMC will be reluctant to cut back or stop the asset purchases, even if things start looking bad on the inflation front. Once inflation gets going, we know it is painful to stop it, and we don't need another problem to deal with.

More than four years later...we now have the same group using neo-Fisherism to explain why the Fed is causing low inflation with low nominal interest rates. With QE2 (and QE of any sort), it was the Fed's fault that we faced so much inflation risk, now it's the Fed's fault that we don't.

Wednesday, November 05, 2014

'Neo-Fisherites and the Scandinavian Flick'

Nick Rowe:

Neo-Fisherites and the Scandinavian Flick: Noah Smith wonders if "reality might topple a beloved economic theory". Well, if you look at Sweden, reality just confirmed that beloved economic theory. The Riksbank raised interest rates because it was scared that low interest rates would cause financial instability. Lars Svensson resigned in protest. Then inflation fell, and the Riksbank needed to cut interest rates even lower than before.
That's only one data point. But there are loads more.

If you don't know how to drive a car, and you don't even have a clue whether you turn the steering wheel clockwise or counter-clockwise if you want to turn right, one good strategy is to borrow a car, and a wide open field, and experiment. Make a random turn of the wheel, and see what happens. The recent data point in Sweden was a natural experiment like that. But Sweden is not a wide open field, and it's hard to borrow a car to experiment like that on regular roads.

An alternative strategy is to ask an experienced driver which way to turn the wheel. Preferably a driver who has managed to keep his car out of the ditch for the last 20 years. Like the Bank of Canada. And if the Bank of Canada says that it cuts interest rates when inflation is falling below target, and it wants to bring inflation back up to target, you listen. They are either right, or wrong and very very lucky.

Never ignore the advice of experienced practitioners, who have had their hands on the steering wheel for a very long time. Unless you have a very good theory about why they might be deluded.

Theory says, and the data confirm, and the advice of experienced practitioners confirms, that if it wants to raise inflation the central bank should first lower interest rates. Then, when inflation and expected inflation starts to rise, it can raise interest rates, higher than they were before. Then, and only then, does the Fisher effect kick in, and we see a positive correlation between inflation and nominal interest rates. That is the Scandinavian flick we saw recently in Sweden. ...

There's more.

'Forecasting Inflation with Fundamentals . . . It’s Hard!'

It's a mystery why inflation is such a mystery:

Forecasting Inflation with Fundamentals . . . It’s Hard!, by Jan Groen, Liberty Street Economics, NY Fed: Controlling inflation is at the core of monetary policymaking, and central bankers would like to have access to reliable inflation forecasts to assess their progress in achieving this goal. Producing accurate inflation forecasts, however, turns out not to be a trivial exercise. This posts reviews the key challenges in inflation forecasting and discusses some recent developments that attempt to deal with these challenges. ...

Sunday, November 02, 2014

Fighting the Last (Macroeconomic) War

Simon Wren-Lewis:

Fighting the last war: It is often said that generals fight the last war that they have won, even when those tactics are no longer appropriate to the war they are fighting today. The same point has been made about macroeconomic policy: policymakers cannot avoid thinking about the dangers of rising inflation, and in doing so they handicap efforts to fully recover from the Great Recession.
Another military idea is the benefit of using overwhelming force. In the case of inflation we have two legacies of the last war that are designed to prevent inflation reaching the heights of the late 1970s: inflation targets and in many countries independent central banks. Do we need both, or is just one sufficient? I think this question is relevant to the debate over helicopter money (financing deficits by printing money rather than selling debt).
Why are helicopter drops taboo in policy circles? Why is it illegal in the Eurozone? The answer is a fear that if you allow governments access to the printing presses, high inflation will surely follow at some point. ...
I think...: yes, in the grand scheme of things we should worry about inflation and debt, but right now we are worrying about them too much and therefore failing to deal with more pressing concerns.

Wednesday, October 29, 2014

'Riksbank and ECB: Reverse Asymmetry'

Antonio Fatás:

Riksbank and ECB: reverse asymmetry: The Swedish central bank just lowered interest rates to zero because of deflation risks. This action comes after ignoring repeated warnings from Lars Svensson who had joined the bank in 2007 and later resigned because of disagreements with monetary policy decisions. What it is interesting is the parallel between Riksbank decisions and ECB decisions. In both cases, these central banks went through a period of optimism that make them raise interest rates to deal with inflationary pressures. In the case of Sweden interest rates were raised from almost zero to 2% in 2012. In the case of the ECB interest rates were raised from 1% to 1.5% during 2011. Also, in both cases, after a significant expansion in their balance sheets following the 2008 crisis, there was a sharp reduction in the years that followed. ... Their policies stand in contrast with those of the US Federal Reserve and the Bank of England...
The consequences of the policies of the ECB and Riksbank are clear: a continuous fall in their inflation rates that has raised the risk of either a deflationary period or a period of too-low inflation. What is more surprising about their policy actions is their low speed of reaction as the data was clearly signaling that their monetary policy stance was too tight for months or years. ...
What we learned from these two examples is that central banks are much less accountable than what we thought about inflation targets. And they ... use ... a policy that is clearly asymmetric in nature. Taking some time to go from 0% inflation to 2% inflation is ok but if inflation was 4% I am sure that their actions will be much more desperate. In the case of the ECB their argument is that the inflation target is defined as an asymmetric target ("close to but below 2%"). But this asymmetry, which was never an issue before the current crisis, has very clear consequences on the ability of central banks to react to deep crisis with deflationary risks.
What we have learned during the current crisis is that an asymmetric 2% inflation target is too low. Raising the target might be the right thing to do but in the absence of a higher target, at a minimum we should reverse the asymmetry implied by the ECB mandate. Inflation should be close to but above 2% and this should lead to very strong reaction when inflation is persistently below the 2% target.

Thursday, October 16, 2014

'Those Whom a God Wishes to Destroy He First Drives Mad'

Brad DeLong wonders why Cliff Asness in clinging to a theoretical model that has clearly been rejected by the data:

... What is not normal is to claim that your analysis back in 2010 that quantitative easing was generating major risks of inflation was dead-on.
What is not normal is to adopt the mental pose that your version of classical austerian economics cannot fail--that it can only be failed by an uncooperative and misbehaving world.
What is not normal is, after 4 1/2 years, in a week, a month, a six-month period in which market expectations of long-run future inflation continue on a downward trajectory, to refuse to mark your beliefs to market and demand that the market mark its beliefs to you. To still refuse to bring your mind into agreement with reality and demand that reality bring itself into agreement with your mind. To still refuse to say: "my intellectual adversaries back in 2010 had a definite point" and to say only: "IT'S NOT OVER YET!!!!"

There's a version of this in econometrics, i.e. you know the model is correct, you are just having trouble finding evidence for it. It goes as follows. You are testing a theory you came up with, but the data are uncooperative and say you are wrong. But instead of accepting that, you tell yourself "My theory is right, I just haven't found the right econometric specification yet. I need to add variables, remove variables, take a log, add an interaction, square a term, do a different correction for misspecification, try a different sample period, etc., etc., etc." Then, after finally digging out that one specification of the econometric model that confirms your hypothesis, you declare victory, write it up, and send it off (somehow never mentioning the intense specification mining that produced the result).

Too much econometric work proceeds along these lines. Not quite this blatantly, but that is, in effect, what happens in too many cases. I think it is often best to think of econometric results as the best case the researcher could make for a particular theory rather than a true test of the model.

Tuesday, October 14, 2014

'The Mythical Phillips Curve?'

An entry in the ongoing debate over the Phillips curve:

The mythical Phillips curve?, by Simon Wren-Lewis, mainly macro: Suppose you had just an hour to teach the basics of macroeconomics, what relationship would you be sure to include? My answer would be the Phillips curve. With the Phillips curve you can go a long way to understanding what monetary policy is all about.
My faith in the Phillips curve comes from simple but highly plausible ideas. In a boom, demand is strong relative to the economy’s capacity to produce, so prices and wages tend to rise faster than in an economic downturn. However workers do not normally suffer from money illusion: in a boom they want higher real wages to go with increasing labour supply. Equally firms are interested in profit margins, so if costs rise, so will prices. As firms do not change prices every day, they will think about future as well as current costs. That means that inflation depends on expected inflation as well as some indicator of excess demand, like unemployment.
Microfoundations confirm this logic, but add a crucial point that is not immediately obvious. Inflation today will depend on expectations about inflation in the future, not expectations about current inflation. That is the major contribution of New Keynesian theory to macroeconomics. ...[turns to evidence]...

Is it this data which makes me believe in the Phillips curve? To be honest, no. Instead it is the basic theory that I discussed at the beginning of this post. It may also be because I’m old enough to remember the 1970s when there were still economists around who denied that lower unemployment would lead to higher inflation, or who thought that the influence of expectations on inflation was weak, or who thought any relationship could be negated by direct controls on wages and prices, with disastrous results. But given how ‘noisy’ macro data normally is, I find the data I have shown here pretty consistent with my beliefs.

Sunday, September 28, 2014

'The Fed Would be Crazy to Worry about Runaway Wages'

Rex Nutting:

The Fed would be crazy to worry about runaway wages: Richard Fisher and Charles Plosser, the two biggest inflation hawks at the Federal Reserve, are retiring soon. But their pernicious ideas will stay alive at the Fed and elsewhere, threatening the middle class with another lost decade of underemployment and low wages.
Fisher, Plosser and the other hawks say inflation is becoming our greatest economic worry. They want the Fed to raise interest rates soon to keep the unemployment rate from dropping too far and to prevent American workers from getting a raise.
They would rather have you to stay jobless and poor.
You may think I’m exaggerating their views, but I’m not. ...

Thursday, September 25, 2014

'What Should Monetary Policy Be?'

Brad DeLong wants to know if he is off his rocker (on this particular point):

What Should Monetary Policy Be?: Chicago Federal Reserve Bank President Charles Evans’s position seems to me to be the position that ought to be the center of gravity of the Federal Open Market Committee’s thoughts right now, with wings on all sides of it taking different views as part of a diversified intellectual portfolio. ... Yet Evans is out there on his own–with perhaps Narayana Kocherlakota beside him. ...

As I see it:

  1. The past decade has demonstrated that to properly reduce the risks of hitting the zero nominal lower bound on safe short-term interest rates, we need not a 5%/year but at least a 6.5%/year business-cycle peak safe short nominal rate.1 With a 3%/year short-term peak real natural interest rate, we need not a 2%/year but a 3.5%/year inflation target instead.

  2. It is likely that the safe natural real rate of interest has fallen by 1%-point/year. That means that a healthy economy properly distant from the ZLB requires not a 3.5%/year but a 4.5%/year inflation target.

  3. It is very important when the economy hits the zero lower bound on nominal interest rates that expectations be that the time spent at the ZLB will be short. To build those expectations, it is important that when the economy emerges from the ZLB it undergo a period in which the long-run inflation target is overshot.

  4. The likelihood is that downward movements in labor force participation that are cementing into structural impediments to employment can be reversed if high demand pulls workers back into the labor force before the cement has set, but only with difficulty otherwise. The benefit-cost analysis thus calls for an additional inflation overshoot in order to satisfy the Federal Reserve’s dual mandate.

  5. If the Federal Reserve aims at a 2%/year inflation target and fails to raise interest rates sufficiently early, it may wind up with 4%/year inflation and have to raise short-term real interest rates to 6%/year–a nominal interest rate of 10%/year–to return the economy to its inflation target. If the Federal Reserve prematurely raises interest rates, it may wind up with 0%/year inflation and wish to lower short-term real interest rates to -2%/year to return the economy to its inflation rate. With inflation at 0%/year, it cannot do that. Thus the risks are asymmetric: raising interest rates later than optimal under perfect foresight carries much lower risks than does raising interest rates earlier than optimal.

  6. Since 1979 the Federal Reserve has built up enormous credibility as the guardian of price stability and has wrecked whatever credibility it had as the guardian of low unemployment. A situation in which the general expectation is that the Federal Reserve will do too little to guard against high unemployment is worse than a situation in which the general expectations is that the Federal Reserve will too little to guard against inflation–”it is worse, in an impoverished world, to provoke unemployment than to disappoint the rentier”.2

  7. The PCE price index is now undershooting its pre-2008 trend by fully 5%: the proper optimal-control response to a large negative real demand shock is not a price level track that falls below but rather one that rises above the previously-anticipated trend path.

IMHO, you need to reject all 7 of the above points completely in order to think that the FOMC’s goal of returning inflation to 2%/year and keeping it there is anywhere close to an optimal-control path for an institution governed by its dual mandate. I really do not see how you can reject all seven.

Moreover, financial markets right now believe that the Federal Reserve’s policy is not going to attain 2%/year inflation–not now, not over the next five years. Since June the on-track-to-recovery Confidence Fairy–to the extent that she was present–has flown away...

Thus right now justifying the Federal Reserve’s policy track seems to me to require rejecting all seven of the points above, plus rejecting the financial markets’ read on monetary policy, plus rejecting the consideration that depressed financial markets–even irrationally-depressed financial markets–should be offset with additional demand stimulus.

Yet only two of the seventeen FOMC participants are with me. Am I off my rocker? Have they been consumed by groupthink? How am I to understand all this?

Sunday, September 14, 2014

'Stupidest Article Ever Published?'

Via email, I was asked if this is the "stupidest article ever published?":

The Inflation-Debt Scam

If not, it's certainly in the running.

Friday, September 12, 2014

Paul Krugman: The Inflation Cult

What accounts for the survival of the inflationistas?:

The Inflation Cult, by Paul Krugman, Commentary, NY Times: Wish I’d said that! Earlier this week, Jesse Eisinger..., writing on The Times’s DealBook blog, compared people who keep predicting runaway inflation to “true believers whose faith in a predicted apocalypse persists even after it fails to materialize.” Indeed. ... And the remarkable thing is that these always-wrong, never-in-doubt pundits continue to have large public and political influence.
There’s something happening here. What it is ain’t exactly clear. ... I’ve written before about how the wealthy tend to oppose easy money, perceiving it as being against their interests. But that doesn’t explain the broad appeal of prophets whose prophecies keep failing.
Part of that appeal is clearly political; there’s a reason why ... Mr. Ryan warns about both a debased currency and a government that redistributes from “makers” to “takers.” Inflation cultists almost always link the Fed’s policies to complaints about government spending. They’re completely wrong about the details — no, the Fed isn’t printing money to cover the budget deficit — but it’s true that governments whose debt is denominated in a currency they can issue have more fiscal flexibility, and hence more ability to maintain aid to those in need...
And anger against “takers” — anger that is very much tied up with ethnic and cultural divisions — runs deep. Many people, therefore, feel an affinity with those who rant about looming inflation... I’d argue, the persistence of the inflation cult is an example of the “affinity fraud” crucial to many swindles, in which investors trust a con man because he seems to be part of their tribe. In this case, the con men may be conning themselves as well as their followers, but that hardly matters.
This tribal interpretation of the inflation cult helps explain the sheer rage you encounter when pointing out that the promised hyperinflation is nowhere to be seen. It’s comparable to the reaction you get when pointing out that Obamacare seems to be working, and probably has the same roots.
But what about the economists who go along with the cult? They’re all conservatives, but aren’t they also professionals who put evidence above political convenience? Apparently not.
The persistence of the inflation cult is, therefore, an indicator of just how polarized our society has become, of how everything is political, even among those who are supposed to rise above such things. And that reality, unlike the supposed risk of runaway inflation, is something that should scare you.

Friday, September 05, 2014

Paul Krugman: The Deflation Caucus

Why is there so much fear of inflation, particularly on the political right?:

The Deflation Caucus, by Paul Krugman, Commentary, NY Times: On Thursday, the European Central Bank announced a series of new steps it was taking in an effort to boost Europe’s economy. ... But its epiphany may have come too late. It’s far from clear that the measures now on the table will be strong enough to reverse the downward spiral.
And there but for the grace of Bernanke go we. Things ... are far from O.K., but we seem ... to have steered clear of the kind of trap facing Europe. Why? One answer is that the Federal Reserve started doing the right thing years ago, buying trillions of dollars’ worth of bonds in order to avoid the situation its European counterpart now faces.
You can argue ... the Fed should have done even more. But Fed officials have faced fierce attacks... Pundits, politicians and plutocrats have accused them, over and over again, of “debasing” the dollar, and warned that soaring inflation is just around the corner..., but despite being wrong year after year, hardly any of the critics have admitted being wrong, or even changed their tune. And the question I’ve been trying to answer is why. What ... makes a powerful faction in our body politic — ...the deflation caucus — demand tight money even in a depressed, low-inflation economy? ...
One answer is ... truthiness — Stephen Colbert’s justly famed term for things that aren’t true, but feel true to some people. “The Fed is printing money, printing money leads to inflation, and inflation is always a bad thing” is a triply untrue statement, but it feels true to a lot of people. ...
Another answer is class interest. Inflation helps debtors and hurts creditors, deflation does the reverse. And the wealthy are much more likely than workers and the poor to be creditors... So perceived class interest is probably also a key motivation for the deflation caucus. ...
And the important thing to understand is that the dominance of creditor interests on both sides of the Atlantic, supported by false but viscerally appealing economic doctrines, has had tragic consequences. Our economies have been dragged down by the woes of debtors, who have been forced to slash spending. To avoid a deep, prolonged slump, we needed policies to offset this drag. What we got instead was an obsession with the evils of budget deficits and paranoia over inflation — and a slump that has gone on and on.

Wednesday, August 27, 2014

'On the Relationships between Wages, Prices, and Economic Activity'

This is from Edward S. Knotek II and Saeed Zaman of the Cleveland Fed:

On the Relationships between Wages, Prices, and Economic Activity: Labor costs and labor compensation have garnered considerable attention from economists in the wake of the financial crisis and recession. Across a range of measures, wage growth slowed sharply during the recession. Recently, wage growth has remained near historically low levels despite improvements in the labor market.
Subdued wage growth has been variously seen as both a cause and a consequence of the slow pace of economic growth and persistently low inflation rates. It also may have contributed to rising inequality. In some forecast narratives, a pickup in wage growth is viewed as a necessary condition for a stronger recovery and rising inflation. In others, it is a natural consequence of a tightening labor market.
This Commentary takes a closer look at the relationships between wages, prices, and economic activity. It finds that the connections among wages, prices, and economic activity are more akin to a tangled web than a straight line. In the United States, wages and prices have tended to move together, and causal relationships are difficult to identify. We do find that wages are sensitive to economic activity and the level of slack in the economy, but our forecasting results suggest that the ability of wages to help predict future inflation is limited. Thus, wages appear to be useful in assessing the current state of labor markets, but not necessarily sufficient for thinking about where the economy and inflation are going. ...

So even if wages do finally begin rising, policymakers shouldn't panic about inflation (wishful thinking).

Friday, August 22, 2014

Paul Krugman: Hawks Crying Wolf

The inflation "obsession" continues despite the fact that there is little evidence that inflation is likely to be a problem. Why?:

Hawks Crying Wolf, by Paul Krugman, Commentary, NY Times: According to a recent report in The Times, there is dissent at the Fed: “An increasingly vocal minority of Federal Reserve officials want the central bank to retreat more quickly” from its easy-money policies, which they warn run the risk of causing inflation. ...
That may well be the case. But there’s something you should know: That “vocal minority” has been warning about soaring inflation more or less nonstop for six years. And the persistence of that obsession seems, to me, to be a more interesting and important story than the fact that the usual suspects are saying the usual things. ...
The point is that when you see people clinging to a view of the world in the teeth of the evidence, failing to reconsider their beliefs despite repeated prediction failures, you have to suspect that there are ulterior motives involved. So the interesting question is: What is it about crying “Inflation!” that makes it so appealing that people keep doing it despite having been wrong again and again? ...
Eight decades ago, Friedrich Hayek warned against any attempt to mitigate the Great Depression via “the creation of artificial demand”; three years ago, Mr. Ryan all but accused Ben Bernanke, the Fed chairman at the time, of seeking to “debase” the dollar. Inflation obsession is as closely associated with conservative politics as demands for lower taxes on capital gains.
It’s less clear why. But faith in the inability of government to do anything positive is a central tenet of the conservative creed. Carving out an exception for monetary policy ... may just be too subtle a distinction to draw in an era when Republican politicians draw their economic ideas from Ayn Rand novels.
Which brings me back to the Fed, and the question of when to end easy-money policies.
Even monetary doves like Janet Yellen, the Fed chairwoman, generally acknowledge that there will come a time to take the pedal off the metal. And maybe that time isn’t far off...
But the last people you want to ask about appropriate policy are people who have been warning about inflation year after year. Not only have they been consistently wrong, they’ve staked out a position that, whether they know it or not, is essentially political rather than based on analysis. They should be listened to politely — good manners are always a virtue — then ignored.

Thursday, August 21, 2014

Inflation, Fear of Inflation, and Public Debt

Posting the video mysteriously causes formatting problems for the blog, so took it down and replaced it with link to the video:

Chris Sims: Inflation, Fear of Inflation, and Public Debt

Friday, August 15, 2014

'Persistently Below-Target Inflation Rate is a Signal That the U.S. Economy is Not Taking Advantage of all of its Available Resources'

Narayana Kocherlakota, President of the Minneapolis Fed:

..I’m a member of the Federal Open Market Committee—the FOMC—and, as a monetary policymaker, my discussion will be framed by the goals of monetary policy. Congress has charged the FOMC with making monetary policy so as to promote price stability and maximum employment. I’ll discuss the state of the macroeconomy in terms of these goals.
Let me start with price stability. The FOMC has translated the price stability objective into an inflation rate goal of 2 percent per year. This inflation rate target refers to the personal consumption expenditures, or PCE, price index. ... That rate currently stands at 1.6 percent, which is below the FOMC’s target of 2 percent. In fact, the inflation rate has averaged 1.6 percent since the start of the recession six and a half years ago, and inflation is expected to remain low for some time. For example, the minutes from the June FOMC meeting reveal that the Federal Reserve Board staff outlook is for inflation to remain below 2 percent over the next few years.
In a similar vein, earlier this year, the Congressional Budget Office (CBO) predicted that inflation will not reach 2 percent until 2018—more than 10 years after the beginning of the Great Recession. I agree with this forecast. This means that the FOMC is still a long way from meeting its targeted goal of price stability.
The second FOMC goal is to promote maximum employment. What, then, is the state of U.S. labor markets? The latest unemployment rate was 6.2 percent for July. This number is representative of the significant improvement in labor market conditions that we’ve seen since October 2009, when the unemployment rate was 10 percent. And I expect this number to fall further through the course of this year, to around 5.7 percent. However, this progress in the decline of the unemployment rate masks continued weakness in labor markets.
There are many ways to see this continued weakness. I’ll mention two that I see as especially significant. First, the fraction of people aged 25 to 54—our prime-aged potential workers—who actually have a job is still at a disturbingly low rate. Second, a historically high percentage of workers would like a full-time job, but can only find part-time work. Bottom line: I see labor markets as remaining some way from meeting the FOMC’s goal of full employment.
So I’ve told you that inflation rates will remain low for a number of years and that labor markets are still weak. It is important, I think, to understand the connection between these two phenomena. As I have discussed in greater detail in recent speeches, a persistently below-target inflation rate is a signal that the U.S. economy is not taking advantage of all of its available resources. If demand were sufficiently high to generate 2 percent inflation, the underutilized resources would be put to work. And the most important of those resources is the American people. There are many people in this country who want to work more hours, and our society is deprived of their production. ...

Paul Krugman: The Forever Slump

The risks from tightening policy too soon are much greater than the risks from leaving policy in place too long:

The Forever Slump, by Paul Krugman, Commentary, NY Times: It’s hard to believe, but almost six years have passed since the fall of Lehman Brothers ushered in the worst economic crisis since the 1930s. ... Recovery is far from complete, and the wrong policies could still turn economic weakness into a more or less permanent depression.
In fact, that’s what seems to be happening in Europe as we speak. And the rest of us should learn from Europe’s experience. ...
European officials eagerly embraced now-discredited doctrines that allegedly justified fiscal austerity even in depressed economies (although America has de facto done a lot of austerity, too, thanks to the sequester and cuts at the state and local level). And the European Central Bank, or E.C.B., not only failed to match the Fed’s asset purchases, it actually raised interest rates back in 2011 to head off the imaginary risk of inflation.
The E.C.B. reversed course when Europe slid back into recession, and, as I’ve already mentioned, under Mario Draghi’s leadership, it did a lot to alleviate the European debt crisis. But this wasn’t enough. ...
And now growth has stalled, while inflation has fallen far below the E.C.B.’s target of 2 percent, and prices are actually falling in debtor nations. It’s really a dismal picture. ... Europe will arguably be lucky if all it experiences is one lost decade.
The good news is that things don’t look that dire in America, where job creation seems finally to have picked up and the threat of deflation has receded, at least for now. But all it would take is a few bad shocks and/or policy missteps to send us down the same path.
The good news is that Janet Yellen, the Fed chairwoman, understands the danger; she has made it clear that she would rather take the chance of a temporary rise in the inflation rate than risk hitting the brakes too soon, the way the E.C.B. did in 2011. The bad news is that she and her colleagues are under a lot of pressure to do the wrong thing from [those] who seem to have learned nothing from being wrong year after year, and are still agitating for higher rates.
There’s an old joke about the man who decides to cheer up, because things could be worse — and sure enough, things get worse. That’s more or less what happened to Europe, and we shouldn’t let it happen here.

Thursday, August 14, 2014

'The Gold Standard and Price Inflation'

David Andolfatto of the St. Louis Fed:

The Gold Standard and Price Inflation: Why doesn’t the U.S. return to the gold standard so that the Fed can’t “create money out of thin air”?
The phrase “create money out of thin air” refers to the Fed’s ability to create money at virtually zero resource cost. It is frequently asserted that such an ability necessarily leads to “too much” price inflation. Under a gold standard, the temptation to overinflate is allegedly absent, that is, gold cannot be “created out of thin air.” It would follow that a return to a gold standard would be the only way to guarantee price-level stability.
Unfortunately, a gold standard is not a guarantee of price stability. It is simply a promise made “out of thin air” to keep the supply of money anchored to the supply of gold. To consider how tenuous such a promise can be, consider the following example. On April 5, 1933, President Franklin D. Roosevelt ordered all gold coins and certificates of denominations in excess of $100 turned in for other money by May 1 at a set price of $20.67 per ounce. Two months later, a joint resolution of Congress abrogated the gold clauses in many public and private obligations that required the debtor to repay the creditor in gold dollars of the same weight and fineness as those borrowed. In 1934, the government price of gold was increased to $35 per ounce, effectively increasing the dollar value of gold on the Federal Reserve’s balance sheet by almost 70 percent. This action allowed the Federal Reserve to increase the money supply by a corresponding amount and, subsequently, led to significant price inflation.
This historical example demonstrates that the gold standard is no guarantee of price stability. Moreover, the fact that price inflation in the U.S. has remained low and stable over the past 30 years demonstrates that the gold standard is not necessary for price stability. Price stability evidently depends less on whether money is “created out of thin air” and more on the credibility of the monetary authority to manage the economy’s money supply in a responsible manner.

Monday, August 11, 2014

'Inflation in the Great Recession and New Keynesian Models'

From the NY Fed's Liberty Street Economics:

Inflation in the Great Recession and New Keynesian Models, by Marco Del Negro, Marc Giannoni, Raiden Hasegawa, and Frank Schorfheide: Since the financial crisis of 2007-08 and the Great Recession, many commentators have been baffled by the “missing deflation” in the face of a large and persistent amount of slack in the economy. Some prominent academics have argued that existing models cannot properly account for the evolution of inflation during and following the crisis. For example, in his American Economic Association presidential address, Robert E. Hall called for a fundamental reconsideration of Phillips curve models and their modern incarnation—so-called dynamic stochastic general equilibrium (DSGE) models—in which inflation depends on a measure of slack in economic activity. The argument is that such theories should have predicted more and more disinflation as long as the unemployment rate remained above a natural rate of, say, 6 percent. Since inflation declined somewhat in 2009, and then remained positive, Hall concludes that such theories based on a concept of slack must be wrong.        
In an NBER working paper and a New York Fed staff report (forthcoming in the American Economic Journal: Macroeconomics), we use a standard New Keynesian DSGE model with financial frictions to explain the behavior of output and inflation since the crisis. This model was estimated using data up to 2008. We find that following the increase in financial stress in 2008, the model successfully predicts not only the sharp contraction in economic activity, but also only a modest decline in inflation. ...

Thursday, August 07, 2014

'How the Incipient Inflation Freak-Out Could Wreck the Recovery'

Tim Duy dealt with this effectively a few days ago (see here too), but it's worth emphasizing:

How the incipient inflation freak-out could wreck the recovery, by Dean Baker and Jared Bernstein: As predictable as August vacations, numerous economists and Federal Reserve watchers are arguing that the nation’s central bank must raise interest rates or risk an outbreak of spiraling inflation. Their campaign has heated up a bit in recent months, as one can cherry pick an indicator or two showing slightly faster growth in prices or wages.
But an objective analysis of the recent data, along with longer-term wage trends, reveals that the stakes of premature tightening are unacceptably high. The vast majority of the population depends on their paychecks, not their stock portfolios. If the Fed were to slam on the breaks by raising interest rates as soon as workers started to see some long-awaited real wage gains, it would be acting to prevent most of the country from seeing improvements in living standards.
To understand why continued support from the Fed is unlikely to be inflationary, consider three factors: the current state of key variables, the mechanics of inflationary pressures and the sharp rise in profits as a share of national income in recent years, along with its corollary, the fall in the compensation share. ...

'Will the US Inflate Away Its Public Debt?'

Ricardo Reis:

Will the US inflate away its public debt?, by Ricardo Reis, Vox EU: Should the US Federal Reserve raise the inflation target from its current level of 2%? And will it? One benefit would be to make hitting the zero lower bound less likely, which would lead to less severe recessions, as Olivier Blanchard, Giovanni Dell’Ariccia, and Paolo Mauro (2010), Daniel Leigh (2010), and Laurence Ball (2013) have argued on this website. Other benefits of higher inflation that Kenneth Rogoff has been emphasising for a while might include accelerating the fall in real wages during the recession, and deflating away debt overhang (Rogoff 2014).1
One of the most indebted economic agents is the government. The federal debt limit has had to be raised repeatedly in the past few years, and at the end of the 2013 fiscal year the gross federal debt outstanding was 101% of GDP – the highest ratio since 1948. It is therefore natural to imagine – like Aizenman and Marion (2009) –that inflating away the public debt is possible, perhaps effective, and maybe even desirable. Using a simple rule of thumb to estimate the effect of higher inflation on the real value of debt, they venture that US inflation of 6% for four years could reduce the debt-GDP ratio by roughly 20%.
However, in our recent work we show that the probability that US inflation lowers the real value of the debt by even as little as 4.2% of GDP is less than 1% (Hilscher, Raviv and Reis, 2014). Why is this estimate so small? We show that there are two reasons: first, the private sector holds shorter maturity debt; second, high levels of inflation in the next few years are extremely unlikely. ...

He concludes:

One way or another, budget constraints will always hold. This is true as much for a household or a firm as it is for the central bank or the government as a whole. If the US government is to pay its debt, then it must either raise fiscal surpluses or hope for higher economic growth; the former is painful and the latter is hard to depend on. It is therefore tempting to yield to the mystique of central banking and believe in a seemingly feasible and reliable alternative: expansionary monetary policy and higher inflation.3 Crunching through the numbers we find that this alternative is not really there.

Thursday, July 31, 2014

Fed Watch: On That ECI Number

Tim Duy (see Dean Baker too):

On That ECI Number: The employment cost index is bearing the blame for today's market sell-off. Sam Ro at Business Insider reports:
...traders agree that today's sell-off is probably due to one stat: the 0.7% jump in the employment cost index (ECI) in the second quarter.

This number, which crossed at 8:30 a.m. ET, was a bit higher than the 0.5% expected by economists. And it represents a year-over-year growth rate of over 2%.

It's a big deal, because it's both a sign of inflation and labor market tightness, two forces that put pressure on the Federal Reserve to tighten monetary policy sooner than later.

The ECI gain was driven by the private sector (compensation for the public sector was up just 0.5%, same as the first quarter), and I would be cautious about reading too much into those numbers. The Fed will take the Q2 reading in context of the low Q1 reading:


The first two quarters averaged a just 0.46% increase, pretty much the same as recent trends of the past five years. And look at the year-over-year-trend:


Nothing to see here, folks. Move along. Benefit costs for private sector workers also accelerated, but I think the Fed will likely interpret this as an anomaly:


Again, not out-of-line with readings both before and after the recession.
Bottom Line:  I understand why market participants might be a little hypersensitive to anything related to wages. Indeed, wage growth is the missing link in the tight labor market story.  But I don't think the Fed will react much to these numbers; they will place them in context of recent behavior, and in that context they are not much different than current trends.  Watch the upcoming employment reports for signs of diminishing underutilization of labor - that is where the Fed will be looking.

Wednesday, July 23, 2014

Another False Alarm on US Inflation

Gavyn Davies:

Another false alarm on US inflation?, by Gavyn Davies: There have been a few false alarms about a possible upsurge in inflation in the US in the past few years... There is an entrenched belief among some observers that the huge rise in central bank balance sheets must eventually leak into consumer prices, and they have not been deterred by the lack of evidence in their favour so far.
Another such scare has been brewing recently. ... As so often in the past, this happened because of temporary spikes in commodity prices, especially oil. But these have usually been reversed before a generalised inflation process has been triggered. ....
It now seems probable that part of the recent jump in core inflation was just a random fluctuation in the data. There have been suggestions that seasonal adjustment may have been awry in the spring.
But the main reason for the lack of concern is that wage pressures in the economy have remained stable, on virtually all the relevant measures. ...
On today’s evidence, there has been yet another false alarm on US inflation.

Friday, July 18, 2014

Paul Krugman: Addicted to Inflation

What does "inflation addiction" tell us?:

Addicted to Inflation, by Paul Krugman, Commentary, NY Times: The first step toward recovery is admitting that you have a problem. That goes for political movements as well as individuals. So I have some advice for so-called reform conservatives trying to rebuild the intellectual vitality of the right: You need to start by facing up to the fact that your movement is in the grip of some uncontrollable urges. In particular, it’s addicted to inflation — not the thing itself, but the claim that runaway inflation is either happening or about to happen. ...
Yet despite being consistently wrong for more than five years,... at best, the inflation-is-coming crowd admits that it hasn’t happened yet, but attributes the delay to unforeseeable circumstances. ... At worst, inflationistas resort to conspiracy theories: Inflation is already high, but the government is covering it up. The ... inflation conspiracy theorists have faced well-deserved ridicule even from fellow conservatives. Yet the conspiracy theory keeps resurfacing. It has, predictably, been rolled out to defend Mr. Santelli.
All of this is very frustrating to those reform conservatives. If you ask what new ideas they have to offer, they often mention “market monetarism,” which translates under current circumstances to the notion that the Fed should be doing more, not less. ... But this idea has achieved no traction at all with the rest of American conservatism, which is still obsessed with the phantom menace of runaway inflation.
And the roots of inflation addiction run deep. Reformers like to minimize the influence of libertarian fantasies — fantasies that invariably involve the notion that inflationary disaster looms unless we return to gold — on today’s conservative leaders. But to do that, you have to dismiss what these leaders have actually said. ...
More generally, modern American conservatism is deeply opposed to any form of government activism, and while monetary policy is sometimes treated as a technocratic affair, the truth is that printing dollars to fight a slump, or even to stabilize some broader definition of the money supply, is indeed an activist policy.
The point, then, is that inflation addiction is telling us something about the intellectual state of one side of our great national divide. The right’s obsessive focus on a problem we don’t have, its refusal to reconsider its premises despite overwhelming practical failure, tells you that we aren’t actually having any kind of rational debate. And that, in turn, bodes ill not just for would-be reformers, but for the nation.

Monday, July 14, 2014

'Empirical Evidence on Inflation Expectations in the New Keynesian Phillips Curve'

Via email, a comment on my comments about the difficulty of settling questions about the Phillips curve empirically:

Dear Professor Thoma,
I saw your recent post on the difficulty of empirically testing the Phillips Curve, and I just wanted to alert you to a survey paper on this topic that I wrote with Sophocles Mavroeidis and Jim Stock: "Empirical Evidence on Inflation Expectations in the New Keynesian Phillips Curve". It was published in the Journal of Economic Literature earlier this year (ungated working paper).
In the paper we estimate a vast number of specifications of the New Keynesian Phillips Curve (NKPC) on a common U.S. data set. The specification choices include the data series, inflation lag length, sample period, estimator, and so on. A subset of the specifications amount to traditional backward-looking (adaptive expectation) Phillips Curves. We are particularly interested in two key parameters: the extent to which price expectations are forward-looking, and the slope of the curve (how responsive inflation is to real economic activity).
Our meta-analysis finds that essentially any desired parameter estimates can be generated by some reasonable-sounding specification. That is, estimation of the NKPC is subject to enormous specification uncertainty. This is consistent with the range of estimates reported in the literature. Even if one were to somehow decide on a given specification, the uncertainty surrounding the parameter estimates is typically large. We give theoretical explanations for these empirical findings in the paper. To be clear: Our results do not reject the validity of the NKPC (or more generally, the presence of a short-run inflation/output trade-off), but traditional aggregate time series analysis is just not very informative about the nature of inflation dynamics.
Kind regards,
Mikkel Plagborg-Moller
PhD candidate in economics, Harvard University

Is There a Phillips Curve? If So, Which One?

One place that Paul Krugman and Chris House disagree is on the Phillips curve. Krugman (responding to a post by House) says:

New Keynesians do stuff like one-period-ahead price setting or Calvo pricing, in which prices are revised randomly. Practicing Keynesians have tended to rely on “accelerationist” Phillips curves in which unemployment determined the rate of change rather than the level of inflation.
So what has happened since 2008 is that both of these approaches have been found wanting: inflation has dropped, but stayed positive despite high unemployment. What the data actually look like is an old-fashioned non-expectations Phillips curve. And there are a couple of popular stories about why: downward wage rigidity even in the long run, anchored expectations.

House responds:

What the data actually look like is an old-fashioned non-expectations Phillips curve. 
OK, here is where we disagree. Certainly this is not true for the data overall. It seems like Paul is thinking that the system governing the relationship between inflation and output changes between something with essentially a vertical slope (a “Classical Phillips curve”) and a nearly flat slope (a “Keynesian Phillips Curve”). I doubt that this will fit the data particularly well and it would still seem to open the door to a large role for “supply shocks” – shocks that neither Paul nor I think play a big role in business cycles.

Simon Wren-Lewis also has something to say about this in his post from earlier today, Has the Great Recession killed the traditional Phillips Curve?:

Before the New Classical revolution there was the Friedman/Phelps Phillips Curve (FPPC), which said that current inflation depended on some measure of the output/unemployment gap and the expected value of current inflation (with a unit coefficient). Expectations of inflation were modelled as some function of past inflation (e.g. adaptive expectations) - at its simplest just one lag in inflation. Therefore in practice inflation depended on lagged inflation and the output gap.
After the New Classical revolution came the New Keynesian Phillips Curve (NKPC), which had current inflation depending on some measure of the output/unemployment gap and the expected value of inflation in the next period. If this was combined with adaptive expectations, it would amount to much the same thing as the FPPC, but instead it was normally combined with rational expectations, where agents made their best guess at what inflation would be next period using all relevant information. This would include past inflation, but it would include other things as well, like prospects for output and any official inflation target.
Which better describes the data? ...
[W]e can see why some ... studies (like this for the US) can claim that recent inflation experience is consistent with the NKPC. It seems much more difficult to square this experience with the traditional adaptive expectations Phillips curve. As I suggested at the beginning, this is really a test of whether rational expectations is a better description of reality than adaptive expectations. But I know the conclusion I draw from the data will upset some people, so I look forward to a more sophisticated empirical analysis showing why I’m wrong.

I don't have much to add, except to say that this is an empirical question that will be difficult to resolve empirically (because there are so many different ways to estimate a Phillips curve, and different specifications give different answers, e.g. which measure of prices to use, which measure of aggregate activity to use, what time period to use and how to handle structural and policy breaks during the period that is chosen, how should natural rates be extracted from the data, how to handle non-stationarities, if we measure aggregate activity with the unemployment rate, do we exclude the long-term unemployed as recent research suggests, how many lags should be included, etc., etc.?).

Tuesday, July 08, 2014

'The Unemployment Cost of Below-Target Inflation'

Carola Binder:

The Unemployment Cost of Below-Target Inflation: Recently, inflation in the United States has been consistently below its 2% target. The situation in Sweden is similar, but has lasted much longer. The Swedish Riksbank announced a 2% CPI inflation target in 1993, to apply beginning in 1995. By 1997, the target was credible in the sense that inflation expectations were consistently in line with the target. From 1997 to 2011, however, CPI inflation only averaged 1.4%. In a forthcoming paper in the AEJ: Macroeconomics, Lars Svensson uses the Swedish case to estimate the possible unemployment cost of inflation below a credible target...

The unemployment rate would be about 0.8% lower if inflation averaged 2% (and presumable lower still if inflation averaged slightly above 2%). ...

Svensson concludes with policy implications:

"I believe the main policy conclusion to be that if one wants to avoid the average unemployment cost, it is important to keep average inflation over a longer period in line with the target, a kind of average inflation targeting (Nessén and Vestin 2005). This could also be seen as an additional argument in favor of price-level targeting...On the other hand, in Australia, Canada, and the U.K., and more recently in the euro area and the U.S., the central banks have managed to keep average inflation on or close to the target (the implicit target when it is not explicit) without an explicit price-level targeting framework.  
Should the central bank try to exploit the downward-sloping long-run Phillips curve and secretly, by being more expansionary, try to keep average inflation somewhat above the target, so as to induce lower average unemployment than for average inflation on target?...This would be inconsistent with an open and transparent monetary policy."

[See the full post for more details.]

Is Wage Growth a Problem?

Josh Bivens:

Is Wage Growth the Problem or the Solution?, by Josh Bivens, WSJ Think Tank: Lots of talk has percolated recently about whether a sudden burst of rapid wage growth would force the Fed’s hand in pulling back monetary stimulus... Some who, like me, do not see any evidence of an imminent wage take-off have argued that the Fed should wait for some evidence of wage inflation before hitting the brakes.
These arguments essentially treat a pickup of wage growth as a problem to be guarded against. But the most conspicuous failure in the U.S. economy over the past generation, by far, has been too slow wage growth for the vast majority of American workers. ...
So one part of the “how much slack” debate that too often goes unaddressed is that there is not only a lack of evidence that wages are about to start growing rapidly but also that it wouldn’t be a big problem if they did. In fact, it would be a good thing.

Monday, July 07, 2014

Fed Watch: Inflation Hysteria Redux

Tim Duy:

Inflation Hysteria Redux, by Tim Duy: I am in general agreement with Calculated Risk on this point:

I also think the economy is picking up, and I agree that as slack diminishes, we will probably see real wage growth and an uptick in inflation.

Moreover, note that this is largely consistent with the Federal Reserve's outlook as well. Recall St. Louis Federal Reserve President John Williams from April, via Bloomberg:

Williams, who forecast the Fed will start raising interest rates in the second half of next year, said inflation has “bottomed out” and will gradually accelerate to the central bank’s 2 percent target. He said prices have been held down by temporary forces such as a slowdown in health care costs.

The Federal Reserve has consistently predicted higher inflation, and consistently been surprised that that inflation has not yet arrived despite rapidly falling unemployment rates. It would appear, however, that their forecasts are finally coming true. Hence, I also agree with Calculated Risk when he says:

On inflation: I'm sympathetic to people like Joe Weisenthal at Business Insider who is looking for signs of inflation increasing; I'm starting to look for signs of real wage increases and inflation too. I just think inflation isn't a concern right now (Weisenthal was correct on inflation over the last several years in contrast to the people who were consistently wrong on inflation).

It is enough to simply say that inflation is coming. That in and of itself is insufficient. Any inflation call needs to be placed in the context of magnitude and expected monetary policy response. Regarding both, follow Calculated Risk's warning:

Monetary policy can't halt the violence in Iraq or make it rain in California - and this is why it is important to track various core measures of inflation.

The Fed doesn't target core inflation. They target headline inflation. But they also believe that headline inflation will revert to core, and as such tend to be more concerned with core inflation in excess of 2%. Consider the history of core inflation since 1985:


I included a 25pb "forecast error" band around the Federal Reserve stated 2% target for PCE inflation; no one believes they can consistently hit 2% in the short-term, hence it is a medium term target. The most obvious feature is that for the last twenty years, core measures of inflation have more often than not been at or below the the upper range of the Fed's error band, especially for core-PCE inflation. Average core-PCE inflation: 1.7%. Average core-CPI inflation: 2.2%. Indeed, if core-PCE were the target, it is fairly clear that the Fed would have been on average undershooting its objective for the past two decades.
It is simply difficult for me to become too worried about inflation given the history of the past twenty years - twenty years in which the US economy was at times substantially outperforming the current environment no less. Underlying inflation simply has not be a problem.
It was not a problem because the Federal Reserve tightened policy multiple times to preempt inflation. Expect the same during this cycle as well - the Fed will begin to gradually raise interest rates sometime next year, and they will maintain a gradual pace of tightening as long as they believe core-PCE will consistently average 2.25% or less. Currently, I anticipate the first rate hike will occur in the second quarter of 2015. If the unemployment rate falls to 5.5% by the end of this year, I would expect the first hike to be in the first quarter of 2015.
What about headline inflation? Headline inflation is at the mercy of the Middle East and the weather, leaving it more volatile than core:


Average PCE inflation since 1994: 1.9%. Average CPI inflation since 1994: 2.4%. Arguably a pretty good track record. It is really no wonder that it is so difficult to motivate the inflation lectures in Principles of Macroeconomics. All the students are twenty or less years old. They simply have no experience with inflation as a troubling 1970s-style phenomenon.
How will headline inflation influence monetary policy? If you combine headline inflation well in excess of 2.25% (I suspect something more like 3%) with tight labor markets and rapid wage/unit labor cost growth, I think the Fed will accelerate the pace of tightening (indeed, the second two conditions alone would probably do the trick). If we experience high headline inflation in the context of weak wage growth, expect the gradual pace of tightening to continue. Under those circumstances, the Fed will believe that headline inflation will depress demand and lessen inflationary pressures endogenously.
Bottom Line: If you are making a short-term bet on higher headline inflation, primarily you are making a bet on energy and food. That bet is about the Middle East and weather, not monetary policy. I don't have an opinion on that bet. If you are betting on inflation over the medium-term, primarily you are making a bet on higher core inflation. More to the point, you are betting against the Fed. You are essentially betting that the Fed will not do what it has done since Federal Reserve Chair Paul Volker - tighten policy in the face of credible inflationary pressures. I would think twice, maybe three times before making that bet.

Monday, June 30, 2014

FRBSF Economic Letter: Will Inflation Remain Low?

Yifan Cao and Adam Shapiro:

Will Inflation Remain Low?, by Yifan Cao and Adam Shapiro, FRBSF Economic Letter: Over the past two years, inflation has remained persistently low. As measured by the core personal consumption expenditures price index (core PCEPI), which excludes volatile energy and food prices, annual inflation has been below the Federal Reserve’s 2% target since April 2012. Given the recent path of inflation, a natural question to consider is how likely it is to remain low in the future. Recent research using financial market forecasts (Bauer and Christensen 2014) shows that inflation will remain low going forward. In this Economic Letter, we examine the outlook for inflation using model-based forecasts. 
We rely on the well-known Phillips curve model and examine its implications for inflation over the next two years. In its most basic form, this model posits that inflation depends on past inflation and a measure of slack in the overall economy. We show that a basic Phillips curve implies that inflation is likely to remain low over the next two years. 
As with any forecasting model, the basic Phillips curve is sensitive to the assumptions inherent in its underlying structure. The basic model has very few components and leaves out several potentially important determinants of inflation. Indeed, over the years, numerous extensions to the basic Phillips curve framework have incorporated additional factors that are likely to affect the dynamics of inflation. In this Economic Letter, we focus on two simple extensions that are potentially important to the current inflation outlook. 
The first extension incorporates anchored inflation expectations with the constraint that long-run inflation eventually returns to the Fed’s inflation target of 2% (see Williams 2006, Stock and Watson 2010, and Cogley, Primiceri, and Sargent 2010). The second extension uses an alternative measure of economic slack that excludes the long-term unemployed and focuses on the short-term unemployed (see Gordon 2013, Rudebusch and Williams 2014, and Watson 2014). A Phillips curve model that incorporates these two extensions predicts a path for inflation that is still low but is higher than implied by the basic model. 
The basic Phillips curve model
The Phillips curve framework is based on the premise that, during times of economic prosperity when overall demand rises higher than overall supply in the economy, there will be increasing pressure to push prices up. By contrast, during times of economic distress when demand falls relative to supply, there is a downward pressure on prices. The model therefore suggests that inflation depends on some indicator of unused productive capacity in the economy, or “slack.” While there are numerous measures of slack, a popular choice among economists is a measure referred to as the unemployment gap. This gap is defined as the difference between the level of the current unemployment rate and what the unemployment rate should be if the economy were operating at its full capacity. This latter measure is referred to as NAIRU, or the non-accelerating inflation rate of unemployment, and an estimate of it is produced by the Congressional Budget Office. The underlying intuition is that, when the economy is in distress, the unemployment rate will lie above NAIRU. 
The basic Phillips curve describes the behavior of current inflation as a function of the past unemployment gap and past inflation. We estimate this model using data going back to 1985. We then use the parameters from our estimates to project future inflation, assuming that the unemployment gap follows some specified future path. We assume that the unemployment rate for the second quarter of 2014 will be 6.3%, as measured in May 2014, and thereafter it will move at a steady pace toward 5.55% by the end of 2015, which is the average unemployment rate projection from the Fed’s most recent Summary of Economic Projections (Board of Governors 2014). 

Figure 1
Projected PCEPI inflation: Basic Phillips curve model

Projected PCEPI inflation: Basic Phillips curve model

Sources: Bureau of Economic Analysis (BEA) and
Board of Governors, Summary of Economic Projections.

Figure 1 depicts actual inflation, measured by the annualized quarterly change in core PCEPI and the projection for inflation using the basic Phillips curve model. The basic model implies inflation is very persistent and projects core PCEPI inflation will remain below 2% through the end of 2015. 
Extensions to the basic model
The basic Phillips curve is a parsimonious model and therefore leaves out a myriad of different variables that may affect the path of inflation. Indeed, throughout the past few decades, economists have extended the basic Phillips curve in a host of different ways. Looking at these variations can help give some insights into how certain components can change the outlook for future inflation. For this Economic Letter, we consider two simple extensions of the model that are particularly relevant given the current situation. 
In our first exercise, we examine how much a credible Fed inflation target would affect the inflation forecast generated by the Phillips curve. Specifically, we impose a restriction that steady-state core PCEPI inflation lies at the Fed’s perceived inflation target, currently 2%. This is equivalent to assuming that, on average, consumers and firms believe that future inflation is “well anchored” around the Fed’s inflation target level (see Williams 2006). The assumption is reasonable if firms are forward-looking, setting prices based on expectations of future demand and cost, and incorporating the Fed’s explicit inflation target. 

Figure 2
Projected inflation: Basic vs. anchored expectations

Projected inflation: Basic vs. anchored expectations

Sources: BEA and Board of Governors, Summary of Economic Projections.

Figure 2 depicts this Phillips curve model that imposes inflation expectations anchored at the Fed’s target, alongside the basic model projection. The modified projection is slightly higher, but still lies below 2% by the end of 2015. This slow movement of inflation from its current level, even assuming anchored expectations at 2%, highlights the strong persistence of inflation implied by the data and the model. Generally, most models of inflation dynamics agree on this key trait, that is, inflation moves sluggishly over time. 

Figure 3
Breakdown of unemployment: Short-term vs. long-term

Breakdown of unemployment: Short-term vs. long-term

Source: Bureau of Labor Statistics.

In our second exercise, we alter the measure of slack used in the Phillips curve inflation forecast. The years since the most recent recession have been marked not just by higher overall unemployment, but also by different durations of unemployment taking divergent paths. As Figure 3 shows, the short-term unemployment rate, defined as the number of people out of work for less than 27 weeks divided by the labor force, has dropped precipitously since the most recent recession ended. In terms of the short-term unemployed, the economy is back to its historical average. By contrast, the long-term unemployment rate has remained elevated. As Robert Gordon (2013) and Mark Watson (2014) recently pointed out, these long-term unemployed may be exerting less upward pressure on wages and prices than the short-term unemployed. For instance, this may be the case if firms compete more for potential employees who have only recently become unemployed than for those whose skills may have eroded or who may otherwise be scarred by prolonged unemployment.
For this exercise, we alter our measure of economic slack to account for this dichotomy. Rather than using overall unemployment, we focus on the short-term unemployed. Specifically, we create a short-term unemployment gap measure by gauging how monthly rates over the 1985 to 2014 sample period deviate from the average short-term unemployment rate. 

Figure 4
Projected inflation: Short-term unemployment as slack

Projected inflation: Short-term unemployment as slack

Sources: BEA and Board of Governors, Summary of Economic Projections.

Figure 4 shows that the projections for inflation using the short-term unemployment gap exceed the projections of the basic model using the overall unemployment gap. If we also impose well-anchored inflation expectations, inflation rises at a relatively fast pace, surpassing 2% by the end of 2015. The reason for the higher inflation projection is that, in terms of the short-term unemployment rate, there is currently little economic slack. In fact, the short-term unemployment rate projects excess demand over the next two years, which implies strong upward pressure on prices. 
Inflation, as measured by the core PCEPI, currently stands below the Fed’s 2% target. A simple empirical Phillips curve implies that inflation will remain relatively low in the near future. Estimating just how low depends a great deal on the assumptions in the model. We test two specific variations to the basic model, altering the measure of slack and the assumptions about inflation expectations. We find that these variations produce some higher projections for future inflation. However, it is difficult to prove that any one specification of the model is the true one. Instead, examining the effects of various specifications can be instructive in exploring how various factors affect forecasts of inflation.
Bauer, Michael D., and Jens H.E. Christensen. 2014. “Financial Market Outlook for Inflation.” FRBSF Economic Letter 2014-14 (May 12).
Board of Governors of the Federal Reserve System. 2014. “Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents, June 2014.” Table 1, Summary of Economic Projections.  
Cogley, Timothy, Giorgio E. Primiceri, and Thomas J. Sargent. 2010. “Inflation-Gap Persistence in the U.S.” American Economic Journal: Macroeconomics 2(1), pp. 43–69.
Gordon, Robert. 2013. “The Phillips Curve Is Alive and Well: Inflation and the NAIRU during the Slow Recovery.” NBER Working Paper 19390. 
Rudebusch, Glenn, and John Williams. 2014. “A Wedge in the Dual Mandate: Monetary Policy and Long-Term Unemployment.” FRB San Francisco Working Paper 2014-14 (May).
Stock, James, and Mark Watson. 2010. “Modeling Inflation after the Crisis.” NBER Working Paper 16488.
Watson, Mark. 2014. “Inflation Persistence, the NAIRU, and the Great Recession.” American Economic Review 104(5, May), pp. 31–36. 
Williams, John. 2006. “Inflation Persistence in an Era of Well-Anchored Inflation Expectations.” FRBSF Economic Letter 2006-27 (October 13).

Friday, June 27, 2014

The Panic Over Inflation Is 'Perplexing'

Greg Ip echoes Tim Duy on 'Inflation Hysteria':

The spontaneous combustion theory of inflation: In the last few weeks, ominous warnings of inflation's imminent resurgence have multiplied... On factual, theoretical and strategic grounds, I find the panic over inflation perplexing.
First, factual. Yes, core CPI inflation has rebounded to 2% from 1.6% in February and today we learned that core PCE inflation has risen to 1.5% from 1.1%. What should we infer from this? Nothing. In the short run inflation oscillates...
Second, theoretical. ... The New Keynesian theory, to which the Fed subscribes, considers inflation a function of slack and expectations. The evidence is pretty persuasive that while slack has shrunk in the last five years..., it remains ample. Expectations, likewise, have oscillated but shown no trend up or down. ...
What if you consider inflation always and everywhere a monetary phenomenon? I consider the money supply pretty useless for forecasting anything, but even if were a monetarist, I wouldn't be worried..., M2 is up just 6.5% in the last year...
Third, strategic. ... Of course, the Fed might wait too long to tighten and inflation could eventually rise above the 2% target. But,... overshooting inflation is clearly a lesser evil than undershooting inflation. This, more than anything else, is why the panic over inflation is misplaced.