The unending (and frustrated) search for inflation

In The Risks to the Inflation Outlook SF Fed researcher Vasco Cúrdia writes:

Figure 1 shows that the median inflation forecast is not expected to return to the FOMC target of 2% until after the end of 2016. The uptick in inflation in the first half of 2014 could lead one to believe inflation is finally on the path back toward its target. However, inflation has shown similar patterns several times before and each time the uptick has never lasted very long. According to this model, we should not see inflation begin to recover more firmly until around the end of 2015.

The model explains that persistent effects from the financial crisis are the main reason inflation is expected to remain low for so long. The financial crisis disrupted the credit market, leading to underinvestment and underutilization of resources in the economy. This slowed the economic recovery and pushed inflation down more than 2 percentage points, according to the model.

In contrast, the model suggests monetary policy pushed inflation up by 0.8 percentage point. This is expected to fall to zero by the end of 2016. Comparatively speaking, monetary policy appears to be far from causing excessive inflation under present circumstances.

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It´s much more straightforward than that. It all boils down to how the Fed handles nominal spending (NGDP). The set of charts illustrate for different periods.

The 1970s harbored the “Great Inflation” because the Fed “manned” NGDP growth on an upward trend. Things get “shaky” when an oil shock hits, but the inflation trend is basically determined by the NGDP growth trend.

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The 2001 recession saw NGDP growth fall way below the trend growth level. When the Fed became “smart” it decreed “forward guidance”, letting everyone know that spending growth would be such as to take NGDP back to the trend level.

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Going into the “Great Recession” the Fed gets “confused” by the oil price shock and lets NGDP growth slide (and then tumble) down, bringing both real output AND inflation down with it!

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The recovery starts off with the Fed introducing QE1. The NGDP “airplane” takes off, but “levels-off” long before reaching the previous “height”.

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So that, at the new lower “cruise level”, we get “phony” nominal stability, which is associated with lower RGDP growth and lower inflation, sometimes temporarily disturbed by oil (supply) shocks.

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Bottom line: If the Fed does not “recalibrate” the “plane´s height”, and accelerates towards it, inflation will simply not get back to target!

8 thoughts on “The unending (and frustrated) search for inflation

  1. You quoted Cúrdia as writing: “monetary policy pushed inflation up by 0.8 percentage point.” Did he specify: Compared with what alternative possible monetary policy? If not, the quoted sentence is meaningless. (In the U.S. system there is no such thing as having *no monetary policy*.)

  2. Pingback: Fed, beware of the inflation! | The Corner

  3. Hi Marcus. You said something I am not comfortable with:
    “the inflation trend is basically determined by the NGDP growth trend.”

    Maybe you mean in the 1970s inflation was basically determined by NGDP growth.
    But I think you mean as a general rule inflation is basically determined by NGDP growth.

    If the latter, I am not comfortable. I think inflation is determined by spending patterns, relative to output. (This is almost, but not quite, like the quantity of money, relative to output.) NGDP is determined by inflation and RGDP. So I would say you have it backwards — or, at least backwards from how I have it!!!

    (I don’t think we can count RGDP. I think we have to count NGDP and adjust for inflation. But that’s a different matter altogether.)

    • Art. here´s your “error”: “NGDP is determined by inflation and RGDP. So I would say you have it backwards — or, at least backwards from how I have it!!!”
      Think hard about this, then go and read Friedman´s “A monetary theory of nominal income”.

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