Where does Yellen get these crazy ideas – 2

Yellen and other high-ranking members of the FOMC are partial to the following type of statement:

There is good reason to believe that inflation will move higher as the forces holding down inflation dissipate further.

One of those forces is the price of oil.

The charts below show that this particular idea lacks foundation. Between 2004 and 2008, there were two back-to-back oil price shocks. The first from 2004 to 2006 and the second in 2007-2008.

Yellen Crazy Ideas2

What to expect when there is an adverse supply shock like an increase in the price of oil? The dynamic AD-AS model tells us that inflation will tend to rise and real growth to fall. In that situation, the best the Fed can do is to maintain nominal spending (NGDP) growing in a stable manner.

Looking at the left side charts, we see that´s exactly what happened, at least until early 2006. Inflation went up a bit and real growth decreased somewhat, but nominal spending growth remained stable. Bernanke took over the Fed as the first oil shock was ending and immediately (given his inflation targeting “preferences”) allowed NGDP growth to falter.

Soon after, the second oil shock materialized, putting pressure on headline inflation (not shown). NGDP growth continued to fall, magnifying the fall in real growth from the oil shock. We know that after mid-2008 NGDP growth tumbled, being negative for the first time since 1937.

The right hand side of the chart depicts the economy over the last five years, after the worst of the crisis passed. Note that inflation was slowly falling long before the drop in oil price in mid-2014.

Why do they expect inflation to move higher, if they are constraining NGDP growth? They´ll be surprised when real growth (in addition to inflation) falls when oil prices dropped!

An economic impossibility theorem: You cannot have rising inflation without rising NGDP growth!

3 thoughts on “Where does Yellen get these crazy ideas – 2

  1. Marcus, what’s your take on today’s employment report that has bloomberg business screaming “bring on the rate hike!”

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