In an environment of little or no inflation, why devote so much time and intellect to the study of inflation?

It seems economics is always prepared to fight again the last war! More than 30 years after inflation has been “conquered”, we´re still skeptical. The latest example of the “devotion” to inflation:

Since controlling inflation is a central monetary policy goal, monetary policymakers focus intently on inflation signals. But they face a major difficulty: inflation data contain a lot of transitory shocks. The presence of the transitory “noise” in inflation data makes it difficult to detect early warnings of sustained movements. Responding to these transitory shocks would be a bad idea[wasn´t it Bernanke?], because doing so would translate into policy swings and reversals and introduce uncertainty and volatility into the economy. Instead, policymakers attempt to respond to the sustained movements in inflation—that is, to underlying trend inflation. Discerning the underlying trend in the midst of the noisy inflation data is a challenging task.

We should not forget that inflation was only conquered when it was acknowledged that it was a monetary phenomenon.

The first chart shows that up trending inflation (noisy process because of price controls and oil shocks) is “married” to rising nominal
spending (NGDP) growth. The second illustrates that down trending inflation is “attached” to falling nominal spending growth.

Inflation Devotion_1

Thereafter, inflation was falling, low and stable, “strolling” hand in hand with stable nominal spending growth. In 2008, however, NGDP fell into a deep hole. The inflation damsel, however, was “rescued”. Who saved her from dropping in the abyss? Most likely that was due to the credibility of her “best man”, the Fed.

Inflation Devotion_2

What that tells us, is that the Fed should be paying attention, not to inflation, but to NGDP, constantly checking to see if it is travelling along the ideal (level) path. The charts below indicate that it is not doing so, having chosen a path that is much too low. Inflation doesn´t really care along which level path nominal spending is travelling, as long as it´s a stable path. The real economy, composed of consumers, businesspersons and workers, flesh and blood characters, cares very much indeed!

Inflation Devotion_3

Observation: Note that in the 1970s, core inflation “reacts” to oil prices. In the 1990s and 2000s, it doesn´t. That´s the difference between an upward trending and a stable NGDP growth! Unfortunately, Bernanke who had even written about this back in 1997 fell into the trap!

2 thoughts on “In an environment of little or no inflation, why devote so much time and intellect to the study of inflation?

    • DA, An AD schock usually comes from a MP error. It´s effect on inflation may vary for many reasons (many more than oil intensity). It´s usually best to correct is as quickly as possible

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