“The Impossibility Theorem”

When your argument centers on interest rates and inflation, you´re bound to arrive at a wrong conclusion.

That´s happened to Ryan Avent´s article “No Exit – Global financial integration is tying central banks hands”, where he concludes:

The balance of risks suggests the Fed should tolerate rising inflation. A faster pace of increase in wages and prices would be a healthy development for the American economy. Inflation has been below 2% for four years; exceeding that level would affirm the Fed’s claim that 2% is a symmetrical target for inflation, rather than a ceiling. A temporarily higher inflation rate might be an annoyance for some Americans, but it is preferable to imploding portfolios and a risk of recession.

Even though Ms Brainard prevailed in March, the debate is sure to continue. The Fed is bound to raise rates again at some point, as inflation rises. Another torrent of mobile capital will then flood in, perhaps swamping the Fed’s attempts to go its own way. The world should brace for more financial storms.

There will be no “rising inflation” as long as the central bank constrains nominal spending (NGDP) growth (that´s the “impossibility theorem”). And if there´s no increase in inflation there will be no need, under the Fed´s operating procedure, to raise interest rates.

The chart indicates, with monthly data on a year over year basis, that from 1993 to 2006 NGDP growth averaged 5.5%; RGDP growth averaged 3.4% (exactly the same average as from 1947 to 1992) and Core-PCE inflation averaged 1.8% (just shy of the implicit (at the time) 2% target.

RA Havoc

From 2007 to the present, NGDP growth averaged only 2.9%; RGDP growth averaged 1.3% while Core-PCE inflation averaged 1.6%.

In the more recent period average 1.6% inflation is just equal average NGDP growth minus average RGDP growth (for the pre 2007 period while average inflation was 1.8%, NGDP growth minus RGDP growth was 2.1%. This may reflect the occurrence of a real positive (productivity) shock in the earlier period, which increases RGDP growth and reduces inflation, under a stable NGDP growth regime).

Much has been said about a supposed fall in “potential output”. I tend to believe that a significant part of that is due to the “demand downgrade”.

Anyway, what Ryan Avent should be writing about is not how an inevitable increase in rates will cause havoc, but how the markets are telling (not constraining, mind you) the Fed that it´s on the wrong track. If only the Fed would talk about a NGDP level target…


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