When your thinking is constrained by the “Phillips Box”, you get “nightmarish solutions”

Grep Ip has an article: The Fed’s Bad Options for Addressing Too-Low Inflation in which he argues that what looks like a dream economy (low inflation & low unemployment) could be a nightmare for the Fed´s chairwoman.

The reason being that, according to the Fed´s Phillips Curve precepts to which the Fed subscribes, when unemployment is this low inflation should move up to the Fed´s 2% target.

Instead, says Ip, inflation may have stabilized around 1.5%, presenting the Fed with unpalatable options: deliberately overheat the economy for years to get inflation back up, then potentially induce a recession to stop it from overshooting; or give up on the 2% target, which could hobble its ability to combat future recessions.

According to Ip, this is not scaremongering, being the logical consequence of how central banks believe inflation operates.

To bolster his argument, Ip puts up a version of the chart below.

And writes:

After every recession since 1982, core inflation has averaged lower than in the previous business cycle and is now averaging below the Fed’s 2% target.

However, he doesn´t mention that core inflation averaged higher after every recession from the mid-1960s to 1982.

Since we believe inflation is a monetary phenomenon, not directly related to the level of unemployment, monetary policy should explain why inflation ratcheted up and then down.

Accepting that the stance of monetary policy is given, not by the level of interest rates but by what is happening to nominal spending (NGDP) growth, the reason for the upward and downward movement of inflation is clear as the chart below illustrates.

It is also clear why, since the 2008/09 recession, average inflation is so much lower than 2%.

The “solution” to the problem does not entail “overheating” followed by “inducing recession” or “letting inflation roam freely”. The Fed has the power and capability of increasing the trend growth rate of nominal spending. Temporarily, during the period spending growth is rising to the new higher trend level, inflation could rise somewhat. Being that what they want, it´s not a problem.

Can the Fed do it? Sure. Just as it reaped rising inflation by producing a rising NGDP growth trend, lowered inflation by producing a falling NGDP growth trend and kept inflation “on trend” by producing a stable NGDP growth trend, it can raise the level of the stable NGDP growth trend, which it stopped doing in 2010.

But, once again, they seem to “fear the monster”!

In other words, they seem to be clueless. The “real people” will continue to pay a high price for their ignorance and unwarrented fear.


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