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Thursday, September 18, 2008

Mishkin: Don't Worry about Inflation

I don't have any disagreement with this:

Don't Worry About Inflation, by Frederic S. Mishkin: ...The Consumer Price Index (CPI) last month rose more than 5% over a year earlier, way above a rate that is consistent with price stability. At the same time, the federal-funds rate is at 2%, so the real interest rate on federal funds -- the interest rate adjusted for inflation -- has turned very negative.

Will this low real interest rate lead to inflation spiraling out of control? Shouldn't the Fed react...? The answer is no.

It is certainly true that central banks should be worried about high headline inflation caused by high commodity prices. After all, households daily pay for energy and food items, and they are a big chunk of people's budgets. But central banks cannot control relative prices for food and energy. When a cold snap freezes the Florida orange crop or a tropical storm hits the gasoline refineries along the Gulf Coast, monetary policy cannot reverse the resulting spikes in prices...

Particularly volatile items like food and energy, which are included in headline ... inflation, are inherently noisy and often do not reflect changes in the underlying rate of inflation...

This is why the Fed pays attention to measures of core inflation, which attempt to strip out or smooth volatile changes in particular prices to distinguish the inflation signal from the transitory noise. ... [R]esearch has shown that ... core measures often are much better than headline indexes at providing a first approximation of the permanent changes to inflation. ...

Of course, the Fed should not be complacent about ... inflation... Headline inflation is certainly way too high. There is always a possibility that the currently high numbers could lead to longer-run inflation expectations becoming unhinged, which would weaken the Fed's nominal anchor and produce rising underlying inflation in the future.

The Fed must preserve the nominal anchor at all costs..., a strong long-term commitment to providing a nominal anchor is crucial to not only keeping inflation under control, but to reducing volatility of unemployment and output growth. Thus the Fed must remain vigilant and ... tighten monetary policy when that is needed to ensure that inflation expectations and underlying inflation remain under control.

But isn't the currently low fed-funds rate ... very accommodative? Doesn't this mean that underlying inflation is likely to rise?

Again, the answer is no. It is true that real interest rates on federal funds and Treasury bills are very low. But we are in the throes of major financial disruption that has led to a slowing economy and a substantial widening of credit spreads, so the interest rates that businesses and households must pay to finance their purchases are not low at all.

As recent events indicate, we are also far from sure that the worst is over. There is still plenty of downside risk to the economy. The Fed not only has to be vigilant on the inflation front, but needs to be ready, if necessary, to respond aggressively to possible negative developments...

At some point in the future, financial markets and the economy will begin to recover, credit spreads will fall and then the current fed-funds rate will be too accommodative. Surely that time is not now.

    Posted by on Thursday, September 18, 2008 at 12:33 AM in Economics, Inflation, Monetary Policy | Permalink  TrackBack (0)  Comments (25)

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