The missing “mechanism”

Lael Brainard gave a speech Understanding the Disconnect between Employment and Inflation with a Low Neutral Rate, in which she tries to build the case for less tightening by the Fed.

Some of her arguments:

…Despite a similar degree of resource utilization, core inflation averaged 2.2 percent from 2004 to 2007, notably higher than the comparable three-year average inflation rate today of 1.5 percent.

Why is inflation so much lower now than it was previously? The fact that the period from 2004 to 2007 had inflation around target with similar unemployment rates casts some doubt on the likelihood that resource utilization is the primary explanation. Similarly, a 12-quarter average is typically long enough that temporary factors should not be the dominant concern.

…So if import prices, resource utilization, and transitory factors together do not provide a complete account, why has inflation been so much lower in the past few years than it was previously?

In many of the models economists use to analyze inflation, a key feature is “underlying,” or trend, inflation, which is believed to anchor the rate of inflation over a fairly long horizon. Underlying inflation can be thought of as the slow-moving trend that exerts a strong pull on wage and price setting and is often viewed as related to some notion of longer-run inflation expectations.

The chart below illustrates two measures of long-run (10-yr) inflation expectations. One is the breakeven rate from TIPS spreads and the other a measure calculated by the Cleveland Fed. [Note: these are expectations for the CPI, which runs about 4 basis points above the PCE].

 

Brainard ponders:

Why might underlying inflation expectations have moved down since the financial crisis? One simple explanation may be the experience of persistently low inflation: Households and firms have experienced a prolonged period of inflation below our objective, and that may be affecting their perception of underlying inflation.

Concluding:

To the extent that the neutral rate remains low relative to its historical value, there is a high premium on guiding inflation back up to target so as to retain space to buffer adverse shocks with conventional policy. In this regard, I believe it is important to be clear that we would be comfortable with inflation moving modestly above our target for a time. In my view, this is the clear implication of the symmetric language in the Committee’s Statement on Longer-Run Goals and Monetary Policy Strategy.

Brainard, however, does not indicate a “mechanism” through which the Fed could move inflation expectations (or underlying inflation) up. Just making it clear “we would be comfortable with inflation moving modestly above our target for a time” is not enough.

In addition, the language is not conducive to agents changing their expectations. Words like “modestly above” and “for a time” just don´t provide the required “punch”.

Back in the early 2000s, inflation was also “too low”. That was, in part, because nominal spending (NGDP) growth had fallen significantly below trend. By reeling spending growth up, running it above trend for a while so that the trend level of spending was recouped, inflation turned up towards the implicit target level.

At present, with both actual and “underlying” inflation “too low”, the Fed should crank up NGDP growth in order to move actual and “underlying” inflation up. When NGDP growth fell deeply below trend in 2008/2009, the Fed never tried to regain the original level of spending.

In other words, there was never a recovery period, with the economy going straight to a “submerged” expansion.

The Fed has close control over nominal spending. Since 2010, however, it has kept spending growth stable at an excessively low level. Therefore, if Brainard wants to get “underlying” inflation moving up, she should start paying attention to what really can accomplish the task.

The chart illustrates, showing recent NGDP growth way below the growth experienced during 2003 – 2005.

Unfortunately, the Fed is “set” in its ways, and will keep mouthing irrelevancies like “little slack” and the “best” path for rate hikes. With that, maybe sooner rather than later, the economy will “deeply disappoint”.

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