“Tales from the crypt”

In his “Inflation lessons from the Asian crisis”, Greg Ip tells the story summarized below:

A financial crisis tipped east Asia into a deep recession in 1997-98, which spread to Russia and then the United States via Long Term Capital Management. To cushion the spillover to America, the Fed first aborted a nascent monetary tightening cycle, then actually cut interest rates. It could do so in part because collapsing Asian demand crushed the price of oil, sending headline inflation below 2%.

Today, we have the mirror image. Surging demand in emerging markets that are at or near capacity has driven up commodity prices at a time when America is awash in unused capacity.

Just as the plunge in the price of oil in 1998 did not signal deflationary pressure in America, its rise today does not signal inflationary pressure here, unless it works its way into expectations and wages, of which there’s no sign yet.

If the Fed were to tighten monetary policy today in response to Asia’s inflation problem, it could be the opposite of the mistake it made in 1998, compounding a deflationary shock at a time when the economy is significantly below potential.

My take is different. What happened back in the late 1990s is very different (not a mirror image) of what´s going on at the present time.

“It all started in 1997”. I have some confidence in that statement because 1997 was when Paul Krugman (here and here) started writing about “speed limits” and how “pushing the economy” would end up increasing inflation which, according to him (FT June 3 1998), was being “masked” by special factors.

The figure below “states my case”. In 1998, the Fed allowed nominal spending to rise above trend. The lowering of the FF interest rate induced by the fall out of the Asian and Russian crisis certainly helped. The subsequent increase in rates had a contractionary effect that ended up throwing spending below trend. This, in turn gave rise to the “too low for too long” FF rate. But, as the figure shows, it is what was required to take the economy back to trend. In fact, Bernanke “inherited” a “stable” economy, but ended up losing it for reasons I discussed in another post.

In the late 1990´s apart from the deflationary effects of the Asian-Russian crisis through their impacts on commodity and oil prices, the US economy was being buffeted by a positive productivity shock. The figure below describes the upward trend in productivity growth.

What happens in that situation is best described by a simple graphical dynamic Aggregate Supply-Aggregate Demand (AS/AD) model.

As the diagram illustrates, when the economy experiences a positive productivity shock, the (short run) AS curve shifts downward and to the right. Assuming the economy was initially in equilibrium (inflation on “target” and real GDP growing according to “potential” (LRAS)), and indications are that it was, keeping nominal spending growth constant (i.e. moving along the AD curve), real growth will increase (unemployment fall) and inflation will decrease. The actual data for the period described in the figures below, show that this was the case.

Core inflation was falling below the 2% “target” and real GDP (RGDP) growth was 1.1 percentage points higher in 1997-00 than in 1992-96. Unemployment was also falling. This situation was the “mirror image” of the “stagflation” 1970s and also something that “defied” the conventional wisdom (see Krugman above). Headline inflation also fell, magnified by the drop in oil and commodity prices. But we notice that headline inflation went back up as soon as oil prices began to increase again in early 1999. It is clear that headline inflation follows the pattern dictated by the index of commodity prices (“All commodities PPI”).

Therefore, by “loosening” monetary policy (be it because inflation fell below “target” or as a defense mechanism against the financial fall-out (LTCM) from the Russian financial crisis), the effect was to increase AD growth and so raise RGDP growth above what it would be and the subsequent tightening (maybe to counteract the rise in headline inflation), destabilized the economy. The interest rate moves are depicted in the figure below.

The diagram below shows the dynamic adjustment of the economy following a positive productivity shock. Essentially, there is a temporary increase in real growth to take the economy to its new (higher) path, along which real growth reverts to “potential”. The 1997-00 period was a clear “RBC moment”.

The discussion above indicates very clearly that “targeting nominal spending growth along a stable path” is preferable to “inflation targeting” (not only because there are difficulties with defining the “appropriate” index). Maybe the monetary policy “tightening” in 1999 was a reaction to the rise of headline inflation. A big mistake as it turned out. The same mistake was made years later by Bernanke, but the consequences this time were much more severe.

I hope the same mistake is not made again, and on this point I totally agree with Greg.

4 thoughts on ““Tales from the crypt”

  1. Marcus, I think all that is right, but I also I´m sure that the FED operated without adjusted information about where was really NGDP. So, only much later it was possible to know how was working MP. In 1998, Greenspan reduced three times the interest rate, based on some indicators of disruptive higher risk premia. After his restablished interest rate to a “normal” level.
    Perhaps to rise interest rates in 1999 (I think of it many times) was a mistake, but seeing very low unemployment and increasing inflation, there were some reasons to do.

    • Luis
      The Fed can get information about spending more easily than about RGDP. Yes, there was the mini panic about LTCM (and the degree of “contagion” that could ensue). I remember well that Greenspan, much more than others, was very conscious of technological progress and productivity growth. But almost all analysts had been saying since early 1997 that he was “behind the curve”. At one point even he had doubts about the low unemployment and low inflation, so he increased rates! … and the economy became unstable. I had an e-mail exchange with Greg Ip about his piece and this is what he said: “Very interesting – your points are extremely well made. The point about NGDP targeting is also made by Scott Sumner”.
      Thank you

  2. Pingback: "Tales from the crypt" – Old but still fresh « Economics Info

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