From Bullard´s presentation it comes out that “Inflation Targeting is Rotten”

On the evening of May 18 James Bullard, President of the St Louis Fed and FOMC voting member, made a speech to the “Money Marketeers of New York University” titled: Measuring Inflation: The Core is Rotten. From the introduction:

In my remarks tonight I will argue that many of the old arguments in favor of a focus on core inflation have become rotten over the years. It is time to drop the emphasis on core inflation as a meaningful way to interpret the inflation process in the U.S. One immediate benefit of dropping the emphasis on core inflation would be to reconnect the Fed with households and businesses who know price changes when they see them. With trips to the gas station and the grocery store being some of the most frequent shopping experiences for many Americans, it is hardly helpful for Fed credibility to appear to exclude all those prices from consideration in the formation of monetary policy.

In critiquing the “volatility argument” for core inflation Bullard says:

Recent experience offers something to ponder in this regard. While many think that the recent financial crisis provides an illustration of the merits of the focus on core inflation, I do not see it that way at all. During the second half of 2008 and into 2009, headline inflation measured from one year earlier fell dramatically and in fact moved into negative territory. This was a signal—one among many, to be sure—that a dramatic shock was impacting the U.S. economy. Inflation was not immune to this shock. The FOMC reacted appropriately with an aggressive easing of monetary policy. Yet the movements in core inflation during this chilling period were far more muted and sent much less of a signal that action was required.

That´s interesting, because one of the reasons for the steep fall in headline inflation in the second half of 2008 was the tight monetary policy the Fed had adopted since late 2007 to counteract the rise in oil and commodities. And contrary to what Bullard argues, the Fed did not react with an aggressive easing of monetary policy, because it was exactly beginning in the second half of 2008 that nominal spending plunged to an extent not experienced since the 1930´s! Clearly, the level of the Fed Funds rate is a very imprecise indicator of the stance of monetary policy. In his dismissal of the “relative price” argument, Bullard states:

The key relative price changes in today’s global economy are for energy and other commodities. Crude oil prices, in particular, are substantially higher in real terms than they were a decade ago and constitute a significant fraction of global expenditure. It is often asserted that energy prices cannot increase indefinitely; that a one-time rise in energy prices only temporarily contributes to inflation; and therefore that it makes sense to ignore such changes. However, the logic of relative prices suggests that if households are forced to spend more on energy consumption, then they have to spend less on the consumption of all other goods, thereby putting downward pressure on all other prices (and all other expenditure shares) in the economy. Ignoring energy prices would then understate the true inflation rate, as one would be focusing only on the prices facing downward pressure because of changing relative prices.

Let´s take a look at some pictures. The following graph shows, from the Atlanta Fed Inflation Project, the behavior of headline inflation – both of the flexible and sticky components.

What stands out is the fact that during the “Great Inflation” of the 1970,s, the “sticky components” became unstuck! That´s what we mean by inflation: a continuing rise in all prices. The following figure shows that it is hard to distinguish between the sticky Headline CPI depicted in the previous graph and the Core CPI.

What transpires is that a relative price change can take place within an inflationary process like during the 1970´s or not, like during the last decade. Over the last several months we´ve been hearing all sorts of arguments for and against targeting headline inflation. That should give us pause regarding inflation targeting because if even policy makers cannot agree on the appropriate target, something is definitely wrong with the concept (maybe it´s “rotten”).

I believe that disagreement provides the most compelling case for a change in target. It turns out that a nominal spending target can explain both the rising inflation of the 1970´s as well as the stable and low inflation after the mid 1980´s up to 2007. It also explains why the “Great Moderation” was lost beginning in 2008.

In the next picture, the rising inflation of the 1970´s is the result of the increasing nominal spending trend followed by the Burns Fed to accommodate the rise in energy and commodity prices. If Burns had acted differently and adopted a contractionary monetary policy in the face of those shocks, he would have imparted a decline in nominal spending, exactly what Bernanke did in 2008! So much for Bullard´s suggestion of targeting headline inflation.

The next figure shows that the stable nominal spending growth up to 2007 is associated with the low and stable inflation of the period (note that real growth was also stable).

The next two pictures indicate that stability was lost when the Fed allowed nominal spending growth to first fall below trend and then plunge.

Maybe it’s time to seriously discuss the nominal spending target proposals that have been put forth by different researchers, including Mankiw, Hall and McCallum in addition to Scott Sumner and David Beckworth, over the last 25 years.

9 thoughts on “From Bullard´s presentation it comes out that “Inflation Targeting is Rotten”

  1. “The FOMC reacted appropriately with an aggressive easing of monetary policy”

    Has the Fed, in its entire history, ever admitted that they screwed up, that they reacted inappropriately?

    Or do they go around patting themselves on the back all the time?

    • Bernanke has admitted he read the developing credit crisis incorrectly.

      Greenspan has admitted that his theory of behaviour of financial market participants was incorrect. (Disingenuously pretending he didn’t know exactly what was going on but chose to turn a blind eye).

  2. “That´s interesting, because one of the reasons for the steep fall in headline inflation in the second half of 2008 was the tight monetary policy the Fed had adopted since late 2007 to counteract the rise in oil and commodities. ”

    JMMN – that is an interesting assertion, but on what do you base that opinion? I wouldn’t see it that way at all. The Fed started cutting rates from a peak of 5.25% in August 2007 onwards until 2% by June 2008. It’s not an utterly indefensible claim that this constitutes a de facto tightening of policy, but I would think you need to provide some evidence for this view. I personally held a bearish dollar and bullish commodity view into summer 2008 on the basis that the Fed was easing policy.

    I think the catalyst for the implosion of the system was China’s halt of its CNY depreciation policy. This triggered an appreciation of the yen and thereby led to all kinds of effects in correlated markets via the wonders of Value At Risk. (This explanation comes from Peter Thiel at Clarium). Mind you, if it hadn’t been that catalyst it would have been something else. It was just time for the unravelling to begin.

    • CB – On your view that MP stance can be defined by interest rates, I´ll let Friedman respond:
      Initially, higher monetary growth would reduce short-term interest rates even further. As the economy revives, however, interest rates would start to rise. That is the standard pattern and explains why it is so misleading to judge monetary policy by interest rates. Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

      • JMMN – if your understanding from what I wrote is that I hold the view that the only variable that matters for the stance of monetary policy is interest rates, then I certainly have not communicated my view with sufficient clarity.

        I said that your claim that the Fed deliberately tightened policy from late 2007 till summer 2008 in order to counteract the rise in commodities was not wholly indefensible, but I do believe that it is in need of being defended. I do sincerely believe that Bernanke did not perceive his stance in summer 2008 as being tight (or tighter than late 2007). He was very late to realize the impact of contracting credit growth (as demonstrated by his public statements at the time, and as he later admitted).

        I do not believe that a general quote from Friedman (argumentum from authority, and also without applying in a nuanced way to the present context) constitutes such a defence.

    • JMMN,

      Well – this is your home, so after this I shall leave you be. But it was your claim that inflation fell in 2008 H2 as a consequence of tight monetary policy from late 07 to mid 08 that was adopted in response to rising commodity prices.

      If it is your view instead that the Fed mistakenly and unintentionally pursued a tight monetary policy from late 07 to mid 08 (that was not sufficient to prevent commodity prices rising) then that has rather different implications for analysis than your original statement.

      Having had a very up close and personal experience of financial markets over that period, I do not happen to think your account fits. I think the Fed’s reduction in interest rates was responsible for the final blow-off move in the dollar and commodities, and that from July 2008 the implosion of risk assets sparked by China’s change to its exchange rate policy (albeit that the spark could have come from anywhere) constituted a massive tightening of credit that mere conventional policy was powerless to offset.

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