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Thursday, March 08, 2007

Inflation Trends Always and Everywhere

This ought to set off an interesting round of discussion:

Inflation trends and the role of central bankers, by Stephen Cecchetti and Anil Kashyap, Commentary, Financial Times: On Friday in Washington the inaugural meeting of the US Monetary Policy Forum brings together academic economists, financial market participants and senior officials of the Federal Reserve system. It features discussion of a report, Understanding the Evolving Inflation Process, and a panel discussion of liquidity and monetary policy.

The report is the product of an unusual collaborative effort between university and senior market economists. We expect it will trigger a combination of academic and applied research.

It contains findings that are important for monetary policymakers. The first is that, over decades, the level and volatility of trend inflation in the Group of Seven industrial countries rose and fell almost in unison.

This synchronisation narrows the economic factors that could have triggered the great inflation of the 1970s and ... the “inflation stabilisation” that began in the mid-1980s. The usual suspects – commodity prices, globalisation, mis­estimates of productive capacity and the like – cannot explain the inflation experience.

The culprit was ... central banks’ interest rate decisions. In the late 1960s central bankers lost control by consistently under-responding to rising inflation and in the mid-1980s they collectively became more assertive and regained control.

Looking at the relationship of actual inflation to inflation expectations, the report finds that, while changes in expectations did help to forecast movements in the inflation trend, they no longer do. Instead, things are the other way round. That is, changes in actual inflation trigger movements in expectations. This is sobering, since it means that controlling expectations may not provide policymakers with the leverage they hoped...

[T]he US Monetary Policy Forum is the next natural step in the Fed’s improved transparency. It is easy to forget that as recently as January 1994, the FOMC did not even announce its interest rate target. On Friday, in front of the press, many of the Fed’s leaders will be taking questions from an audience of money managers, market economists and US representatives of foreign central banks.

Twenty-five years ago, at the height of the great inflation, prices were rising at an annual rate of more than 10 per cent in more than half the world’s industrialised countries. Today, inflation is below 4 per cent in all of them. The conference report suggests that this change was the result of a shift in the behaviour of central banks, not of changes in the structure of the economy or anything to do with the stability or instability of the relationship between inflation and unemployment. ...

[E]xpectations are not likely to become unhinged until after trend inflation changes, so the Fed should not take too much comfort from the current confidence exhibited by markets. Instead, as the report suggests, continued vigilance to keep actual inflation contained is what is important.

I will be among those defending inflation targeting, but still listening closely to criticisms of the inflation targeting approach.

Update: Here's more from Greg Ip of the Wall Street Journal:

Experts Warn Fed Risks Worse Inflation By Focusing Too Much on Expectations, by Greg Ip, WSJ: A group of prominent experts on Federal Reserve policy said ... the central bank puts too much weight on inflation expectations, which ... could lead to complacency in the face of an inflation threat.

The conclusions of the study ... suggest that the Fed is risking higher inflation over the next few years, which could require more drastic increases in interest rates later on. But Fed officials are unlikely to agree or to change their current interest-rate stance as a result. ...

The study was written by economists Stephen Cecchetti of Brandeis University; Peter Hooper of Deutsche Bank; Bruce Kasman of J.P. Morgan Chase; Kermit Schoenholtz of Citigroup; and Mark Watson of Princeton University.

In theory, if the public expects inflation to rise, it is more likely to set wages and prices accordingly, and those expectations become self-fulfilling. For the same reason, if expectations are stable, inflation is more likely to remain low. This view plays an important part in Fed policymaking...

A "significant factor influencing medium-term trends in inflation is the public's expectations of inflation," Fed Chairman Ben Bernanke said in February. "It is encouraging that inflation expectations appear to have remained contained."

However, the study says that since 1985, surveys of the public's expectations of inflation have largely lost their ability to predict the direction of inflation. Now, "expectations seem more likely to follow than lead … inflation."

In an interview, Mr. Cecchetti said the study's findings suggest that the Fed risks letting inflation rise in the "medium term," and that interest-rate actions to address inflation "will be too late. It suggests they need to be more vigilant."

The study also disputes the Fed's view that inflation has become less sensitive to whether the economy is operating above or below its normal capacity and level of employment.

Mr. Cecchetti said that means there is a risk that with the economy now operating above its normal capacity, prices and wages could start to rise, and expectations would then follow.

But the Fed is likely to dispute these findings. Its staff research has found that by looking at inflation expectations, the Fed is better at adjusting interest rates in anticipation of swings in employment and inflation. That improved response may have, in turn, made inflation more stable, which could explain why it is less likely to rise or fall in response to a shift in expectations. ...

Whichever came first, the chicken or the egg, inflation and inflationary expectations chasing each other upward is bad for the economy.

Update: David Altig, in response to this post:

MT says "I will be among those defending inflation targeting", but on my quick reading the Cecchetti et al study does not seem to support that position ... the Great Inflation of the 70s was reversed well before inflation targeting came into vogue...

My respond to David would be along the lines of this article from The Economist discussing the Cecchetti et al study:

...monetary policy was simply too loose ... central bankers of the 1970s failed to adhere to the modern “Taylor rule”, a formula that links the appropriate level of short-term interest rates to the deviation of output from its trend and inflation from its target. Of course John Taylor, a Stanford economist, did not formalise his rule until 1993. But even without this guide, central banks should not have flunked the basic tenets of sound money.

Neither the Taylor rule, inflation targets nor any other bits of the modern central bankers' toolkit were necessary to end high inflation. But the scholars think these tools have helped to keep inflation down...

    Posted by on Thursday, March 8, 2007 at 01:07 PM in Economics, Inflation, Monetary Policy | Permalink  TrackBack (0)  Comments (38)

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