Beware of dumb advice

Ms Mees in this Vox article released today seems to think the Fed should emulate the ECB and “target” headline inflation. Her main argument:

Relying on core inflation instead of headline inflation, as the Fed does, is justified in case core inflation is a better predictor of headline inflation than headline inflation itself. Core goods and services tend to be subject to nominal price rigidities, while non-core goods, like agricultural commodities, oil, natural gas etc., have their prices set in auction markets.

For much of the 20th century, core inflation has been both less volatile and more persistent than the inflation rate of non-core goods. However, the integration of China and India in the global market added more than 2.3 billion consumers and producers to the global economy. They entered as suppliers of core goods and services and as demanders of non-core commodities. The result has been a major, persistent, and continuing increase in the relative price of non-core goods to core goods (Buiter 2008).

Ms Mees, like a bunch of other people, apparently think inflation is a “price phenomenon”, so that an increase in a subset of prices is a danger signal. Relative price changes often take place, sometimes due to supply factors (a reduction in the supply of energy like in the 1970´s, for example) sometimes due to demand factors (an increase in demand for “non core” goods due to the “integration of China and India in the global economy”).

But relative price changes can take place within an inflationary process like in the 1970´s or not, like in the 2000´s. The figure below illustrates the difference very clearly.

In the 1970´s, the Fed accommodated the relative price rise with expansionary monetary policies – viewed as a rising trend in nominal spending). At present, nominal spending is way below the trend level path, indicating monetary policy is “tight”. So Ms Mees and her “think alike” group want the Fed to “tighten” even more!

The real lesson: stop targeting rates – inflation and interest rates. Target NGDP – nominal spending – level target instead.

3 thoughts on “Beware of dumb advice

  1. The best part of Mees’ article is near the end:

    “Even if the current spike in headline inflation proves to be transitory, past experience suggests that it may well lead to a permanent increase in real hourly wages.”

    Egad, No!!! The possibility of that happening always fills me with a deep sense of dread and the urge to tighten monetary policy to forstall it (not).

  2. Take a look at this related paper:

    http://www.nber.org/papers/w13615

    I find it intriguing.

    “We use the estimates of the pure inflation and aggregate relative-price components to answer two questions. First, what share of the variability of inflation is associated with each component, and how are they related to conventional measures of monetary policy and relative-price shocks? We find that pure inflation accounts for 15-20% of the variability in inflation while our aggregate relative-price index accounts most of the rest. (…) Second, what drives the Phillips correlation between inflation and measures of real activity? We find that the Phillips correlation essentially disappears once we control for goods’ relative-price changes. This supports modern theories of inflation dynamics based on price rigidities and many consumption goods. “

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