By embracing a wrong theory, the Fed goes astray

This piece gives a nice overview “Central Banks Looking to Reduce Stimulus Face Quandary of Falling Inflation – Weak growth in prices questions traditional model of linking output and prices”:

According to central bankers, inflation is generated by the gap between the demand for goods and services and the economy’s ability to supply them. When that output gap is wide, inflation is lower, and when it is narrow, prices grow more quickly. Low inflation is a symptom of a weak economy, something they want to avoid as much as high inflation, a sign of an overheated economy.

To boost inflation, central banks stimulate demand by lowering interest rates, encouraging households and businesses to borrow and spend. As the volume of goods and services that people want to buy nears the limit of the economy’s capacity to supply them, wages rise, as do prices, generating inflation.

But try as they might, central banks have been unable to reach their inflation targets over recent years, despite their success boosting growth and lowering jobless numbers. That has raised questions about the reliability of the traditional link between the output gap and prices.


…central bankers appear willing for now to look beyond the past few months of weak inflation numbers as they shift away from easy money policies. Faith in output gap theory is one driver. Some also are growing worried about other problems. For example, recent speeches from Fed officials and the minutes of the last meeting suggest a growing concern about financial stability as asset prices rise.

What if inflation is not generated by the “gap”? Then, all that follows is false. Instead of recognizing that simple fact, the Fed introduces new concerns like financial stability, which is endangered by the rise in asset prices.

However, asset prices have been rising for many years, even though the economy remains “bogged down”.

William Dudley, president of the New York Fed, who has a permanent seat at the FOMC voting table, was very clear about his “model preference”:

“If we were not to withdraw accommodation, the risk would be that the economy would crash to a very, very low unemployment rate and generate inflation,” Dudley said. “Then the risk would be that we would have to slam on the brakes and the next stop would be a recession.”

The panel below is “living proof” that the “gap model” of inflation is false.

Throughout the 1990s and into the mid-2000s, inflation was first falling and then remained low. All the while, the output gap was highly positive. Note one interesting fact. During all of those years, “potential output” was being revised up towards actual output.

Conversely, since the crisis, “potential output” has been chasing down to converge to actual.  Despite the negative output gap, inflation has not been falling, but remained low and stable.

To remain faithful to its preferred theory, the Fed is also revising down its estimate of the “natural” rate of unemployment!

To see why inflation has fallen and remained low and stable for the past 25 years, you only have to look to monetary policy, the stance of which is given by the flat trend level of nominal spending (NGDP) growth.  The other charts in the panel show unemployment and real output growth. Also, note that the 1991-2006 period includes the tail end of the 1990-01 recession and the 2001 recession. The present period excludes the 2008-09 recession altogether.

Note that while inflation and unemployment “converge” to similar values in the two periods, NGDP growth remains significantly lower in the 2010-17 period, keeping real output growth also at a lower level. With monetary policy (NGDP growth) so “tight” (relative to what it was during most of the 1991-06 period), no wonder both inflation and real growth remain so low!

Bottom line: If the Fed doesn´t change its views, keeping the faith in the “gap model” with “financial stability frills” added, the outlook cannot be promising.


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