A “simple” answer

To Eric Rosengren´s of the Boston Fed question:

How Should Monetary Policy Respond

to Price Increases Driven by

Supply Shocks?

There´s a ´”simple” answer: Get the economy back to a reasonable nominal spending trend level and than keep spending growing at a suitable constant rate (before the economy fell off the cliff, that rate was around 5%).

With the economy evolving along that level target, you don´t react to either price increases due to things like “oil shocks” or to price decreases due to “positive productivity shocks”, you just keep spending growing at the chosen rate along the trend target.  If the economy falls below it monetary policy strives to pull the economy back up and vice versa, if the economy goes above the trend path. The Central Bank will get “high marks” just by “protecting” the economy from unwanted “demand shocks” – the only type of shock that the Fed can control.

That´s for the future. Given the present modus operandi, confusion reigns, starting with the definition of inflation itself!

Inflation is best defined as a “sustained increase in ALL prices”, a monetary, not a real or price phenomenon. But people tend to worry about particular prices.  So when the “stripping” out of volatile prices from consideration takes place, technically correct if what you are interested in is the trend of inflation, the media starts “howling” and the consumer feels he´s being duped by the monetary authorities. And that´s why Rosengren had to deliver the speech I linked to.

William Gavin of the St Louis Fed just came out with a note that shows that “headline” CPI inflation is “gasoline powered”. The figure below, cloned from his note, shows that just by “stripping” gasoline prices from “headline” inflation, “headline” and “core” inflation show almost no difference. Nice to know, but so what?

As the next picture indicates, gas prices at the pump are “fueled” by oil prices at the wellhead. Going one step further back you naturally ask: what´s fueling prices at the wellhead? Is it “supply” or “demand”? Probably a bit of both. Again, for the Fed and monetary policy, so what?

Reminds me of the Bank of England back in 1999 worrying about a surge in house prices in the south east region of the country (the London-Calais corridor) and if that warranted a rise in rates. Later it became known that the (temporary) rise in home prices was due to French immigrants escaping higher marginal (50% higher) tax rates in France!

But the fundamental question remains unanswered: Why did patterns (valid for most commodities) changed dramatically after 2001? I don´t know if I´m right, but I think China in the WTO (December 2001) must be an important part of the answer.

Update: It appears many Fed presidents/officers decided to speak about the same thing on the same day. This is John Williams of the San Francisco Fed on the subject of “inflation” (and it´s nuances):

Higher gasoline prices are at the top of the list of factors that have been a drag on the economy and will continue to be so for some time. Over the past year, the price of gas at the pump has jumped by about a third. This takes money out of the pockets of consumers and reduces their ability to make other purchases. In addition, the jump in energy prices raises uncertainty, saps confidence, and makes both consumers and businesses more cautious about spending. Indeed, consumer confidence, as measured by surveys of households, remains mired near its recessionary lows.

Let me now turn to inflation. Here are some of the questions we need to ask at this juncture: What is the current inflation situation? What are the underlying forces driving prices? What are the prospects for inflation in the medium term? And what is the appropriate response of Federal Reserve monetary policy?

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