Puzzling Surprises

Lael Brainard, a prominent member of the Fed’s board of governors, made the following admission in a recent speech, highlighting what policymakers see as economic puzzle: “At a time when the unemployment rate has fallen from 8.2% to 4.4%, core inflation has undershot our target for 58 straight months.”


Albert Edwards, strategist at Societe Generale, is equally flummoxed: “It is incredible to think that this US recovery, the third longest in history, has seen core PCE barely exceed its 2% target and for only three months in 2012. That shows how deeply entrenched deflationary pressures are.”

What is an “incredible puzzle” is why they think it´s a puzzle or incredible! That´s what comes out from PC (Phillips Curve) reasoning, which closely associates unemployment (or growth) with inflation.

If they cared to look at recent history, they wouldn´t be puzzled. During the longest expansion in US history, the ten years from March 1991 to February 2001, unemployment came down from 7.6% to 3.9% while the core PCE inflation undershot the (then implicit) 2% target for 60 straight months!

Also, the 1990s expansion saw robust real growth of 3.4%, not the paltry 1.7% seen in this expansion.

While the two expansions (the longest and third longest) show falling unemployment and low and stable inflation, their real growth experience is markedly different.

A stable rate of inflation is the outcome of a stable rate of nominal growth (the province of monetary policy). As the chart shows, both expansions experienced stable nominal growth, albeit at very different rates, with nominal growth in this expansion being significantly lower.

Why then, one may wonder, the inflation rate is so similar in the two expansions.

We must remember that the Fed has a 2% target, implicit in the earlier expansion and explicit since January 2012. That works to make the inflation rates in the two periods be similar.

The explicitness of the 2% target at present causes anxiety in monetary policymakers, something which was absent in the previous period. After all, the 2% target was just implicit, causing no anxiety if inflation was slightly above or below the target!

By adhering to PC reasoning, monetary policymakers have “strangled” the economy. By keeping nominal growth too low, a “healthy” real growth rate is impossible. What´s worse, by not being able to “exercise its muscles” the economy will be (permanently) atrophied!

The Fed, however, will be content because it will think it has fulfilled its dual mandate. The markets, not so much!


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