Jamie Galbraith on the Fed, the economic outlook, and inflation targeting:
A deer in the headlights, by James Galbraith, Commentary, UK Guardian: In my last column on the American economy, I asked if worse was soon to come. It was. And it has. First quarter GDP growth has slowed to a 1.3% annual rate. Housing fell by over 17%. Business equipment and software investment also fell. Meanwhile inflation picked up... Again one has to ask: does the Federal Reserve know what it's doing?
At a conference ... at the Levy Economic Institute of Bard College, Fed Governor Ric Mishkin delivered an appraisal. For three years, he noted, real growth had equaled 3.5 percent, only recently slowing to "a more moderate and sustainable pace". And this, he said, is a good thing...
Looking ahead, Mishkin was judiciously upbeat... Of course, Mishkin is obliged to say such things. He would have delivered that speech whether he believed it or not... But reality checked in just one week later. One point three percent isn't moderate; it's slow. ... For the moment, inflation is now running at roughly twice the Fed's notional target.
According to normal practice, when inflation jumps the Fed should tighten, and when growth stumbles it should ease. Hello rock. Hello hard place. What is a central banker to do?
The most likely answer is, freeze. Mishkin's speech prefigures this. He carefully acknowledged every known aspect of the slowdown so far. But he still projects that the economy will, nevertheless, continue to expand at a "moderate and sustainable" pace. This projection, and not current facts, governs the policy stance. ... Deviations below the forecast - such as just occurred - are simply evidence that the future will be stronger, not weaker, than the recent past. Policy should therefore not respond. Thus, the deer in the headlights.
I asked a theoretical question. Mishkin's vision of the economy, I offered, was one of Dantesque darkness: with the pits of hell all around, the flames of inflation licking at our feet, and only the valiant Central Banker as our guide and protector... But suppose, instead, all those fires had gone out twenty-five years ago? Apart from the recent blip, plainly induced by oil prices, we have not actually seen inflation since the early 1980s. How can one tell, I asked, that it hasn't died?
The response was heartfelt and energetic. Inflation remains, Mishkin averred, always and everywhere a monetary phenomenon, even though the impact of policy cannot actually be measured by any known indicator, whether money growth or interest rates. It is therefore an ever-present threat. To suspect otherwise is to court disaster. A vast literature confirms this, and the overwhelming majority of economists agree. When I noted that I'd made a career out of making up my own mind..., he responded, "Yes I know, and I think you're crazy."
This was very satisfying, of course, but it didn't answer my question. There is a good case ... that globalization killed inflation decades ago... But you can't prove this, unless you first accept the possibility, and then investigate it. The fixed belief that inflation lives precludes this. And so it prevents the Federal Reserve from reacting ... to a slowdown that prior policy plainly caused, and that is, equally plainly, gathering force.
Do I think that cutting rates alone will be sufficient to put things right? No. The Fed has, in my judgment, done serious damage, and it will take serious efforts to repair it. ...
But we ... won't start, until we take seriously the possibility that "monetary" inflation isn't a threat. That would require a full review of the monetarist (and post-monetarist) inflation theory that has now held sway for a generation, which isn't going to come from the present crew at the Fed.
Still, it would be a good start, if the Fed were simply to take seriously the finale of Ric Mishkin's speech. After saying, "However, I continue to believe that the current stance of monetary policy is likely to foster sustainable economic expansion and a gradual ebbing in core inflation," Mishkin wrapped up with these words:
As always, future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth as implied by incoming information.
As I've noted in the past when debating Jamie, I'm with Mishkin in terms of the Fed's policy procedures, i.e. that it's important to keep inflation in check. To me, the argument about inflation is like arguing we should take the bars off the windows because nobody has broken in for a long time.