When poor economic reasoning prevails

Suddenly, we seem to have forgotten the most basic of lessons: that inflation is a monetary phenomenon.

However, given that inflation remains low, in spite of low unemployment, the absence of inflation is dubbed a mystery. In the opposite direction, a few years ago when unemployment was high, the absence of disinflation/deflation was also dubbed a mystery.

The chart shows that inflation, measured by the PCE-Core has remained stable and low for a very wide range of unemployment rates. This should give pause to proponents of the Phillips Curve.

Unfortunately, it doesn´t and the reason for that may be, as Gavyn Davies has said:

[I] want to argue that the existence of the Phillips Curve (PC) is essential for the conduct of modern monetary policy. Without the PC, the whole complicated paraphernalia that underpins central bank policy suddenly looks very shaky. For this reason, the PC will not be abandoned lightly by policy makers.

Later he writes, partly repeating himself maybe for emphasis:

If the observed PC can in fact appear to slope in any direction, depending on the circumstances, why does it matter? Basically, because it is the bedrock of all New Keynesian (NK) models that underpin monetary policy in all of the major central banks today. Remove the PC, and the central bankers are floundering.

In the same vein, Tim Duy has argued in defense of the conventional wisdom:

Let’s revisit this from San Francisco Federal Reserve Resident John Williams:

If you look until 2015 or so, the inflation data basically followed our models, emphasizing the role of weakness in the economy. Where this mystery has happened is really in the last year or two. I view both inflation picking up faster than expected in early 2017 and now the pullback as just part of the variability that’s going to happen. I don’t see any signs that somehow the inflation process is fundamentally changed.

I’ve been doing this a long time, and the Phillips curve has been declared dead far more times than Mark Twain.

This is representative of the conventional wisdom at the Fed, summed up succinctly as adherence to a basic expectations-augmented Phillips curve as a primary policy guide. As unemployment falls toward and below full employment, capacity constraints in the economy tighten and eventually create inflationary pressures. The central bank needs to offset these pressures via tighter policy to contain inflation and maintain inflation expectations, the center of gravity for actual inflation over time.

Later, he writes:

Critics of the conventional policy argue that central bankers should be much more cautious about using the Phillips curve as a policy guide. Proponents argue that abandoning the Phillips curve now will leave the Fed behind the curve when fighting the inevitable inflation ahead of us.

Proponents maintain the upper hand on Constitution Ave. And I think I think they are not without good reason. From their perspective, policy outcomes when following the conventional wisdom compare favorably to the monetary policy debacle that was the 1970s. Given that success, why risk pursuing an alternative strategy?

To visualize the Fed´s successes and failures he puts up a version of the chart below.

And writes:

As is evident in the chart (he only has the upper chart), policy outcomes deteriorate beginning in the late 1960s with increasing and increasingly variable unemployment and inflation. The situation does not full revert to more consistency with the mandates until the mid-90s, by which time inflation returns to a low level, generally 2 percent or below while the economy remains more consistently near full employment. Importantly, at least according to the Fed’s conventional wisdom, inflation expectations stabilized at a level consistent with price stability since the mid-90s.

What about the high unemployment rates during the Great Recession? Doesn’t that substantial deviation from mandate indicate a failure of the Fed’s framework?

I would argue that it does not. First, I would argue the roots of the Great Recession lay more in regulatory failures than monetary policy failures. Second, the fact that inflation did not spiral to zero and below despite such high unemployment indicates that the Fed was largely appropriately responsive during that period. Third, the economy returned to meeting the Fed’s mandates in fairly short order; outcomes did not spiral out of control as they did in the 1970s.

The bottom part of the chart helps understand what is happening “upstairs”. Monetary instability – a rising trend for NGDP growth – in the 1970s explains the wide range of inflation and unemployment.

Monetary stability – a stable growth of NGDP – in the 1990s to mid-2000s – explain the outcome for inflation and unemployment being contained inside the “stability circle”, with the two parts of the mandate – low stable inflation (close to 2%) and maximum employment (unemployment close to NAIRU) – being “satisfied”.

Contrary to what Tim Duy argues, the bottom chart clearly indicates that monetary policy failure – letting NGDP growth fall precipitously – explains all the deviation of unemployment from the mandate.

When monetary policy stabilizes the growth of NGDP, in spite of the fact that NGDP remains far below the previous level, the outcome reenters the “stability circle”. Only now, the stable level of NGDP growth is significantly lower than previously, with the major victim being the downgrading of the level and growth rate of real output.

A few years ago, commenting on the absence of disinflation in the face of rising/high unemployment in 2008-2011, Bob Hall wrote:

“Prior to the recent deep worldwide recession, macroeconomists of all schools took a negative relation between slack and declining inflation as an axiom. Few seem to have awakened to the recent experience as a contradiction to the axiom.” Bob Hall (2013)

Since then, it appears the “axiom” is being contradicted again, with falling/low unemployment not affecting inflation.

Tim Duy does not “explore” the fact that “inflation expectations stabilized at a level consistent with price stability since the mid-90s.”

First, why did inflation expectations stabilize? Monetary policy, as measured by NGDP growth stabilized at that point. And since NGDP growth remains stable after a short period of instability in 2008-09, inflation expectations remain “anchored”.

As the chart indicates there´s no “inflation puzzle”, either in the absence of disinflation in 2009-11 or in the absence of higher inflation more recently. In both instances, alternative measures of long-term (10-year) inflation expectations remain stable. The short-lived fall in the TIPS breakeven rate in 2008-09 is directly related to the strong and temporary fall in NGDP growth observed in the chart above.

To cap a month of very poor economic reasoning we were given the latest Geneva Report on the World Economy carrying the title “And Yet It Moves Inflation and the Great Recession”.

The executive summary states:

Over the last decade, the developed world has been hit by the deepest recession since the Great Depression and a rollercoaster in commodity prices. And yet, core inflation has been both low and relatively stable.

A rule of thumb that inflation is always near 2%, and perhaps more often than not just a bit beneath it, has been quite reliable. The young, or those with short memories, could be forgiven for looking condescendingly at their older friends who speak of inflation as a major economic problem. But, like Galileo Galilei told his contemporaries who thought the Earth was immovable, “Eppur si muove” (“and yet it moves”).

Since most societies regard stable inflation as a goal, it is tempting to describe this solid anchoring of inflation as a great achievement of monetary policy. But what if it was just luck?

Will the great anchoring soon be followed by a great bout of inflation, or by a descent into deflation, just as the Great Moderation was followed by the Great Recession? The starting point of this report is a contrast between what happened to inflation after the Great Recession with what standard theories might predict. We note that around 2010, pretty much all standard theories seemed to point towards volatile and potentially unanchored inflation. Yet, inflation was stable and anchored. Why?

They take more than 130 pages to try to answer the question. Unfortunately they don´t shed light.

We see how misguided they are right at the introduction to the first chapter:

This chapter argues that this confidence in the stability of inflation is misplaced. Policymakers and the public are at danger if they ignore inflation because they think it is yesterday’s problem. Far from being comforting, we argue that the low and stable inflation of the last few years is quite puzzling. This should create doubts about what we know about controlling inflation, and so reduce our confidence in being able to keep it in line in the near future.

What is puzzling is their total lack of understanding of what determines inflation. This view was summarized in a recent speech by former Fed Governor Tarullo, who wrote:  Monetary Policy Without a Working Theory of Inflation:

The substantive point is that we do not, at present, have a theory of inflation dynamics that works sufficiently well to be of use for the business of real-time monetary policy-making. 

Furthermore, unbeknownst to the authors of the Geneva Report, is the reason why the Great Moderation was followed by the Great Recession!

Bottom Line: With such poor economic reasoning, how can you expect better monetary policy going forward even with a change in the Fed´s command that promises no change or even a change for the worse?


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