‘Faith-based interest rate hiking’ – Understanding Yellen

It should be very worrying when we hear central bankers (Yellen) say things like:

“I will not say the committee clearly understands what are the causes of low inflation now”


“Our understanding of the forces driving inflation is imperfect.”

The present situation of low inflation is being touted “the mystery of the missing inflation. Maybe that´s why the Fed says it has an imperfect understanding.

According to their preferred model, with unemployment this low, inflation should be rising. The fact that it isn´t, makes it a mystery.

Yellen has faced that ‘mystery’ before. In her last months as a Board Member in 1996, she tried to nudge Greenspan into hiking rates. The reason being, you guessed, because unemployment was “too low”.

To recap:

Yellen – Aug 96

Now, suppose someone, and that someone is not I, firmly adheres to the view that the economy is currently operating at NAIRU and not below it. Can one point to anything in the recent pattern of wage and price behavior that would provide strong evidence against that view? Here I would agree with Governor Meyer; I think the answer is no.

On the other hand, historical evidence strongly suggests that NAIRU is higher than 5.4 percent, so it would be both dangerous and foolish to discount the possibility that the modest uptick in compensation that we are now seeing is the beginning of a process that, if left unchecked, will lead to gradually accelerating inflation.

Yellen – November 96

I agree with the staff that we may well be living on borrowed time and that inflation will eventually accelerate if the unemployment rate remains at its current level, as in the Greenbook forecast. Although I believe there is strong evidence that NAIRU has declined below 6 percent, it seems difficult to use the data in hand at this point to defend the proposition that it is as low as 5.2 percent.

Yellen – Dec 96

To my mind, labor markets are undeniably tight. You remarked last time, Mr. Chairman, that we should be careful not to lull ourselves into a false sense of security about incipient wage pressures by reading too much into that suspiciously low third-quarter ECI, and I agree with that.

So, I still feel that we need to avoid complacency about the potential for inflationary pressures to emerge from the labor market down the road. But while I think we cannot rule out the possibility that this long expansion is about to end with a period of stagflation and that that is a significant risk over the term of this forecast, that outcome is by no means a certainty.

This is what was going on around the meeting dates.

She could not rule out the “possibility that the long expansion was about to end with a period of stagflation”. What transpired was the exact opposite: robust real growth, falling unemployment, and falling inflation!

The obvious conclusion is that the labor market is an unreliable guide to monetary policy, and it seems Yellen´s faith in the Phillips Curve model is almost as big as the Pope´s in God!

Now, let me compare 1996-97 with 2015-17.

What do we see? Unemployment is on a downtrend, both then and now, although it is lower at present. Inflation is low in both instances, although a bit lower now. Real output growth is significantly lower now.

So it appears that low/falling unemployment is consistent with low/falling inflation, independently if real growth is ‘high’ or ‘low’.

I´ve already noted that the labor market is not a reliable guide to monetary policy. The reason being that unemployment adjusts to any (stable) nominal growth trend. Inflation does the same, which indicates that having an explicit inflation target may cause unwanted ‘friction’ if the stable inflation rate is below the target rate. Note that in 1996 there was no explicit inflation target, so the Fed was ‘happy’ with ‘low inflation’. Now it is worried about losing credibility.

The last chart solves the ‘mystery’. NGDP or nominal spending growth is relatively stable in both periods. That is consistent with low unemployment and inflation. However, the level of the stable nominal growth trend is much lower at present, explaining the much lower real growth rate.

In the presser following the FOMC September meeting, Yellen said: “if we conclude inflation drop not transitory, it would require an alteration in monetary policy.”

The successive appeals to temporary or transitory factors to ‘explain’ why inflation is low (despite low unemployment) over the past several years strain credulity (or the definition of transitory). More likely it´s Yellen´s way to justify clinging to her (misguided) faith.

What would the “alteration in monetary policy” look like? This chart, borrowed from David Beckworth, clearly shows why the economy is so “subdued” (kinder word then “depressed”).

In 2010, the Bernanke Fed interrupted the recovery, ‘blocking’ additional spending growth. That tells us that NGDP growth has to be pushed up. The ‘alteration’ in monetary policy would then ‘naturally’ lean toward establishing an NGDP Level Target.

Why was the recovery ‘interrupted’? With Bernanke being an ardent (‘faith’ again) inflation targeter, just as in 2008 he was afraid of the inflationary effects of the jump in oil prices, that may have happened again in 2010, especially given the similarity in oil price changes in both periods.

Why the recovery is not bolstered at present? Likely because Yellen is afraid of the inflationary effect of low unemployment. In that case, to the Fed, growth has to be constrained further!

Bottom line: OMG! That said, what does the Fed need? A ‘freethinker’.


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