An AD shock spits in their faces but they don´t feel it!

This is how insensitive FOMC participants are. Typical comment:

From Vice Chair Stanley Fischer:

“I’m not very worried,” Fischer told an audience at the Council on Foreign Relations. “The lower inflation that we’ll get from the lower price of oil is going to be temporary.”

He also said lower oil prices were “a phenomenon that’s making everybody better off.”

He gets it wrong on both counts!

The chart shows daily 10-year breakeven inflation and oil price.

Spit in the face_1

Between mid-2003 and mid-2008, there were two back to back significant oil shocks, with prices more than quadrupling over the period.

Note that despite the strong increase in oil prices, inflation expectations remain stable, even falling and becoming more stable during the second leg of the shock.

The reason the oil shock did not affect inflation expectations will be seen below.

Notice, however, that when a gargantuan negative demand shock hits, oil prices and inflation expectations tumble.

Later, when the environment turned “peaceful” again, oil prices stabilized at a high level and inflation expectations fluctuated quite a bit, but showed no trend, responding to the on/off nature of monetary policy (the QE´s). And when the taper begins, inflation expectations “settle down”.

In mid-2014, oil prices and inflation expectations drop significantly. This is consistent with a negative demand shock. In this case the oil price drop is not “making everybody better off”, but is a reflection of reduced nominal growth expectations, “making everyone worse off”!

When I put up the chart showing NGDP growth, things become clear.

Spit in the face_2

The reason rising oil prices did not increase inflation expectations in 2003-08, is due to the fact that, contrary to what happened in the 1970s, NGDP growth remained stable (in the 70s it showed a rising trend). Interestingly, in 1997 Bernanke had said that the impact of an oil price shock depended on the behavior of monetary policy!

As soon as Bernanke takes over at the Fed, NGDP growth drops, which is consistent with the fall in inflation expectations observed in the first chart. When NGDP growth sinks, so does inflation expectations and oil prices. This is the prototype negative AD shock.

More recently, the Fed has talked a lot about policy “normalization”. But the simultaneous fall in inflation and inflation expectations make them sound “funny”. To counter that impression, they allege that the low inflation observed is a temporary thing, associated with the fall in oil prices, and that this effect will soon “dissipate”. And in order for the Fed not to fall behind the (inflation) curve, they have to “act” now!

They miss the fact that the joint behavior of oil prices and inflation expectations is reflecting the fall in nominal growth expectations. In fact, since the middle of last year, monetary policy, as gauged by NGDP growth has been tightening. But our genius monetary policy makers think monetary policy has been extremely accommodative!

On the 16th they are likely to throw salt in the wound. Any pain will likely be temporary because the economy has been “duly prepared”!

5 thoughts on “An AD shock spits in their faces but they don´t feel it!

  1. This blog post is irrefutable and needs no praise from me. A note to Market Monetarists: 4% NGDP growth looks too small. We see on these charts that 6% works better.

      • Hello, Marcus, I did read that. In general I agree that demand is somewhat weak, but I think market monetarist model has difficulties dealing with positive supply shocks. Not because of the model itself, but because of how we “measure” (or estimate) the input variables. Inflation numbers come out fast, therefore, people tend to see low inflation as weak demand, but that will only be know later, with careful analysis of what is going on with production/consumption. In the case of oil, I would also argue that looking only to oil numbers is misleading. Oil is just one form of energy, we should look at production/consumption of all sources of energy. My guess is that those are also increasing. Oils is not falling just because some low cost producers are pumping more. Even if we see demand for oil that is “lower than expected” does that mean that energy consumption / production is lower than expected ? Not sure ….

  2. China was assumed to be going to absorb the production of huge new gas fields in Qatar, Australia and elsewhere, and now it’s not. “Some low cost producers” is actually 80%-90% of production if you look at the cost curves. The US is so desperately over-supplied that they’ve just legalised oil exports. It’s a steep demand curve that did intersect at a steep part of the supply curve. A small shift left in D had a huge impact on price, and then that cartel-supported supply curve just collapses to the right. And the price tells the tale.

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