What´s wrong with macro (and the Fed) in two short sentences

From Scott Sumner:

Why then are they planning on raising interest rates?  They seem to be relying on flawed NK models that suggest tight labor markets cause higher inflation.  And they notice that unemployment has recently fallen to 5.3%, and may decline further.

But these NK models are simply wrong; low unemployment does not cause inflation.  Rather unexpectedly high inflation (when caused by demand shocks) causes low unemployment. And monetary policy drives inflation.   The NK models have causation reversed.  The Fed is acting like a bystander waiting for the economy to bring inflation on line, whereas actually the Fed determines inflation.  But to do so they need to ease monetary policy when they are likely to fall short of their target.

Going visual:

Wrong with macro and Fed
You can get many combinations of inflation and unemployment, depending on the shocks that hit the system. For example, in the mid and late 90s, a combination of a positive productivity shock, for a while accompanied by a negative oil price shock, is behind falling inflation and unemployment. In the early 00s, a negative demand shock (Fed mistake) which brought NGDP growth down was accompanied by rising unemployment, while inflation didn´t move much at all.

In 2008-9, a very strong negative demand shock (the Fed again) brings inflation forcefully down and unemployment jumps.

Although they appear not to like being bystanders, monetary policy makers act as if they were. But they are “restless”, especially since many of them have never had the chance to increase interest rates. With that, they begin to “see things” (like an economy that´s “picking up” bringing inflation in its wake!)

With a low and stable NGDP growth that would be quite a feat!

Almost five years later, they are very likely to pull a “Trichet trick”. And we well know the consequences.

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