Arnold Kling made an interesting comment about the Federal Reserve:
I can think of at least three reasons why the Fed is not pursuing expansion with more determination. First, current policy is much closer to optimal for banks than it is for the country as a whole. This suggests a Fed controlled by banks. Second, the Fed may be intimidated by those who oppose faster expansion. Third, the Fed is just very slow to change direction. One story for the 1970s is that the Fed kept under-estimating the shifts in the Phillips Curve and the increases in the natural rate of unemployment. It kept following inflationary policies because it was slow to adapt to reality. Similarly, it appears now that the Fed is slow to adapt to downward shifts in aggregate demand. It is adjusting gradually while conditions are deteriorating rapidly. In the 1970s, the Fed took too long to tighten, and now it is taking too long to loosen.
I disagree with the first point (tight money hurts banks—check out their stock prices), and agree with the second. But it’s the third that intrigues me.
Suppose the Fed and ECB are big lumbering institutions, like the Catholic Church. They develop a set of myths that guide them. In the 1960s it was the myth that a bit higher inflation is actually a good thing, because of the Phillips Curve. So from 1965 to 1981 inflation and inflation expectations moved relentlessly higher. As early as 1968 Phelps and Friedman had shattered the idea of a stable Phillips Curve. By the 1970s it was clear that inflation wasn’t buying lower unemployment. But the Fed kept inflating. Monetarist theory was a fringe idea, and the Fed is very much an establishment institution. Only in 1981 (not 1979 as many wrongly believe) was there so much disgust with inflation, and such a widespread understanding of the natural rate hypothesis, that the Fed was able to reverse course and squeeze inflation out of the economy. And when they made that decision in mid-1981 it happened really fast. Monthly inflation rates quickly fell from 10% to 4%, and basically stayed low thereafter. But even now I’m amazed that it took 16 years for them to realize they were on the wrong track.
So the Fed’s like a charging rhino that finds it hard to re-evaluate its trajectory and change direction. How does that fit the recent history?
Although we think of the Great Moderation as having stable inflation, it’s not quite that simple. Inflation has fallen from 4% in the 1982-89 period to 1% in the last three years. And expected inflation has fallen even more sharply. Here’s some estimates from the Cleveland Fed:
I used to have a sort of Whig view of the history of the Fed. They did all sorts of really stupid things in the Great Depression and the Great Inflation, and then they finally found the right policy. This led to low and stable inflation. The last few years, and especially the last few days, have disabused me of that view. Here’s an interesting excerpt from The New Republic article I cited in the previous post:
There is no doubt that predictable price levels are a necessary aspect of monetary credibility. But for many on the right, low inflation is not a matter of good policy, but an ideological dogma: inflation must always be fought, regardless of the state of the economy, and regardless what the data tell us. As Dallas Federal Reserve President and CEO Richard Fisher described it last summer, he was “committed to keeping inflation low and maintaining the credibility gained so painstakingly by former Fed Chairman Paul Volcker. I will remain steadfast in my resolve to keeping inflation low and stable.”
If Fisher was really for “stable” inflation, he’d be horrified that inflation has dropped to only 1% over the past three years. But I have a feeling that Fisher is not horrified by this instability, this drop in inflation. Instead, he seems to exalt in the never-ending fight against inflation. The Volcker story is of course a myth. He reduced inflation to 4% in 1982, and then stopped. Why did he stop? Because unemployment rose to 10.8%. Something to do with the “Phillips Curve,” which the Volcker worshipers now insist doesn’t exist. And then he made no further attempt to reduce inflation. Only in the 1990s did inflation fall to the lower trajectory we now associate with the Great Moderation. Volcker was content to allow 4% inflation, although he now argues that a return to 4% inflation would be awful.
So the Fed has a new set of myths to replace the Phillips Curve. And as a result of these myths they are gradually driving inflation expectations lower and lower. They were supposed to stop at 2%, but it now seems that if low inflation is good, even lower inflation is better. Look closely at the graph above and you’ll see expected inflation has fallen below 1.5%. Some people at the Fed (like Chicago President Evans) would like to see more stimulus, even if it meant 3% inflation. But the Fed is an institution with a momentum of its own, and it’s not clear that even Bernanke could turn it around (nor whether he wants to.)
This won’t last forever. Economists will eventually see that Fed policy is causing all sorts of damage to the economy–and the federal budget. When that occurs another Volcker will finally call a halt to the “Great Disinflation.” Let’s hope this time we finally get it right—5% NGDP growth, level targeting.
Update: After I wrote this I realized my comments on the Phillips Curve seem inconsistent. I was criticizing the idea of a long run trade-off, not the short run trade-off we saw in 1982.
PS. No offense to rhinos, one of my favorite animals. I like old things, and the rhino head reminds me a bit of what the dinosaurs must have looked like. Any comments about their inability to change direction are not meant to be accurate, but merely reflect the way humans perceive them.