No consensus on inflation

Steven Williamson has a post – “Core Inflation” – where, maybe unconsciously, he shows that inflation targeting is “dangerous”. From his conclusion:

To say how a central bank should be responding to particular observed price movements, we need some solid theory concerning the welfare effects of inflation, how monetary policy affects inflation, and some solid measurement to tell us about the quantitative effects. I don’t see anything solid that justifies the Fed’s focus on core inflation measures. Indeed, one could, I think, make a better case for looking at headline inflation measures.

He´s surely being provocative, but is essentially saying that “looking at inflation can be bad for your health”. I wholeheartedly agree with that. But I don´t agree that we need a “solid theory…”. We already have that. And as I´ll try to show, it was exactly because the Fed failed to heed to the “solid theory” in 2008 that a “normal” recession became “Great”. People tend to think of inflation as a “price phenomenon”. As the link to the Plosser speech in his post shows, that´s WRONG:

Some fear that the strong rise in commodity and energy prices will lead to a more general sustained inflation. Yet, at the end of the day, such price shocks don’t create sustained inflation, monetary policy does. If we look back to the lessons of the 1970s, we see that it is not the price of oil that caused the Great Inflation, but a monetary policy stance that was too accommodative. In an attempt to cushion the economy from the effects of higher oil prices, accommodative policy allowed the large increase in oil prices to be passed along in the form of general increases in prices, or greater inflation…

Below I show a set of pictures (once again) that perfectly illustrates that when monetary policy is accommodative you get a rising trend for nominal spending growth accompanied by highly volatile (no trend) in real GDP growth. Conversely, when nominal spending growth is stable (no trend), real GDP growth is also stable. The story behind the “Great Moderation” was clearly one associated with a stable nominal spending growth path, which contrasts quite clearly with the rising nominal spending trend of the “Great Inflation” years.

The figures below show that during an inflationary period – increases in all prices – no price is “sticky”. The figures depict the behavior of “sticky” and “flexible” headline CPI.

During the “Great Inflation” years, up to 1979, both sets of prices move together. Note that you still get relative price changes, but within an inflationary process. The disinflation from 1980 to 1983 is also characterized by simultaneous movements in both sets of prices. The picture is very different during the post 1984 years. “Flexible” prices move a lot (and even fall – deflation), while “sticky” price changes are relatively low and stable. Stability was achieved not because the Fed was targeting “inflation” (be it from sticky or flexible prices) but because, in practice, it kept nominal spending evolving along a stable growth path.

And how did he do that? From the quantity theory, the Fed managed to keep MV stable by offsetting movements in velocity (V) with opposite movements in money (M). The next figures illustrate this point in recent years, in two situations characterized by rising “flexible” price inflation. The first, shown in green bars on the inflation graph above, corresponds to the final period of Greenspan at the Fed helm – 2004-05. The second, shown in yellow depicts the 2007-08 period.

In the first period, money growth closely offsets velocity (money demand) changes. In the second period we observe that after mid 2008, the fall in velocity (rise in money demand) is accompanied by a fall in money growth. From the QTM, the only outcome possible is a fall in nominal spending (PY=NGDP)!

The next graph shows this is exactly what happened, with nominal spending dropping way below “trend”. After that point (mid 2008) the recession that began in late 2007 turned “Great”. As this post shows, that´s the point that marked the soar in unemployment, the plunge in employment and the strong contraction in non residential investment and all measures of spending.

This last point connects well with Williamson´s smack down post on Christina Romer´s op ed at the NYT this weekend. According to CR:

the elevated unemployment rate appears to reflect mainly cyclical factors, particularly a lingering shortfall in consumer spending and business investment and that: This diagnosis suggests that the appropriate remedy is to stimulate demand.

To which SW responds:

So, how can Romer state with any confidence that consumer spending and business investment have fallen short of what they should be? She does not say. Where is the empirical evidence? What is this demand that we are trying to stimulate?

To which I respond: “Steve, look at the pictures” and at the way monetary policy erred!

Update: The whole discussion about which “inflation” just won´t go away. Today two FOMC voting memebers, Yellen and Evans, respectively made a speach and released a paper on the subject. Just goes to show how precarious is the IT “thing”. Better to read and reflect on the Scott Sumner and Beckworth analysis – suggesting that the Fed move to NGDP level targeting. The references are linked to on the “Suggested Readings” on the right side bar under the titles: “The Case for NGDP targeting” – S. Sumner, and “How to Narrow the Fed´s Mandate” – D Beckworth.

Update (4/14): The discussion about the “ideal inflation” to target expands further:

This is St Louis Fed chief Bullard:

Of course, if the evidence shows that core PCE is not the best measure to focus on for policy purposes, exploring other options may make sense. One alternative measure could include all components but put less weight on those that have highly volatile prices. Such a measure would avoid systematically excluding certain prices and would more accurately reflect consumers’ expenditures. Additionally, studies have shown that other existing “core” measures, such as PCE trimmed-mean or PCE weighted-median inflation, may be better predictors of headline PCE inflation than core PCE.2 In the end, the policymakers’ goal is to use the inflation measure that helps them achieve low and stable headline inflation in the long run.

And here is Andolfatto, a VP (Research) at the St Louis Fed:

What, if anything, justifies looking at price indices that strip out components of the index? A cynical view is that the Fed may prefer core to headline because it evidently makes the Fed’s performance look better (in terms of keeping inflation low). This cynical view conveniently ignores the fact that headline inflation is frequently below core.

3 thoughts on “No consensus on inflation

  1. I certainly did not say that inflation targeting was a bad thing. I’m just questioning the conventional focus on “core” inflation measures.

  2. Pingback: Fed’s Yellen on Inflation-Daily Forex and Stock | Daily Forex and Stock

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