Price shocks and Central Bank mistakes

Tony Yates debates Simon Wren-Lewis who debates Kocherlakota…:

…However, whether symmetry is desirable is debatable. From an academic perspective, symmetry follows only from the fact that we choose to approximate what would be in the interests of agents in the model with a function that is symmetric.  From a practical perspective, it’s clear to me that deviations below target pose a greater risk to monetary stability than deviations above, because they involve the potential for the conventional policy instrument to get trapped at the zero bound, and require costly, unreliable discretionary fiscal stimulus as a helping hand, and recourse to unconventional measures of still uncertain merit.

Simon comments on the proposal that the objective be clarified such that it’s understood that the Fed targets two year ahead forecast inflation. Simon characterises the BoE as having ‘operated until quite recently what appeared to be exactly this two year benchmark’, plotting a chart that shows the two year ahead forecast pretty close to target through the years of the great moderation.

In my view Simon overstates the influence of the two year horizon.  Policy was conceived of like this in the early days of independence.  Partly because of an exaggeration of the generality of an early paper of Svensson’s that assumed there was a two year lag between a policy change and a change in inflation.  But quite soon afterwards, and particularly once senior people became aware of the unrepresentativeness of that Svensson paper, communication began to stress that the horizon was elastic, and, in fact, depended on the shocks hitting the economy.  During the great moderation years the horizon, if there was one, was less binding.  Shocks were smaller, so the economy would be projected to return to base quicker; and there were fewer trade-off-inducing shocks, requiring fewer conscious forecast deviations from target. It took the crisis to make use of the elasticity always stressed in the horizon.

I get the sense that the discussion is pretty inane, being just a ruse to make people think there´s a serious debate going on!

Most central banks made the original mistake of reacting aggressively to the 2007-08 oil price shock. The mistake was so blatant that most economies went into a “depressed state”.

Some, unfortunately, were dumb enough to repeat the mistake later on, as the charts illustrate. In Sweden, in addition to oil prices, the Riksbank was also worried about “debt levels and property prices” (to the despair of Lars Svensson, who at least acknowledged the initial mistake).

The charts also indicate that things didn´t go “off the rails” during the period of milder but persistent oil/commodity shocks of 2000-05. Maybe the “acute” nature of the 2007-08 shock, with the Fed under the management of an “IT” fan, made the difference. But that only shows how “inflation” is a bad, even dangerous, target to pursue!

In late 2010 and early 2011, when oil prices jumped after having tumbled during the “Great Recession” of 2008-09, the Fed was “smart” enough not to repeat the mistake, being content in keeping things in the “new normal” state.

(Note: “Price shock” is calculated as the difference between headline and core PCE inflation)

Update: If only Bernanke had listened to himself. In 2003 he said:

Because inflation expectations are now more firmly tied down, surges and declines in energy prices do not significantly affect core inflation and thus do not force a policy response to inflation to the extent they did three decades ago. Indeed, rather than leading to a tightening of monetary policy, increases in oil prices today are more likely to promote consideration of increased policy ease–a direct and important benefit of the improved control of inflation.

And that´s exactly what was being done at the time. Despite persistent oil/commodity shocks, monetary policy was eased in the second half of 2003 (“forward guidance) to lift NGDP back to trend (see chart for US below).

Inane Debate_1


Inane Debate_2

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