Archive for the Category Inflation


Is an NGDP Phillips Curve somehow “wrong”?

I touched on this issue over at Econlog, but I’ll try again here in slightly a different way.

The original Phillips Curve from 1958 had nominal wage inflation on the vertical axis.  (Actually the original original PC was developed by Irving Fisher in the 1920s, and used price inflation.) Then American economists switched to price inflation in the 1960s.  In the 1970s and 1980s, economists accepted the Natural Rate Hypothesis and the expectations-augmented Phillips Curve was developed:

When inflation is higher than expected you are in a boom, and when it’s lower than expected you are in a recession.

But inflation probably not the right variable, for standard “never reason from a price level change” reasons.  Higher inflation can reflect more AD, or less AS:

So what is the right variable?  As far as I can tell, the Phillips Curve should be using unexpected changes in NGDP:

So here’s my question to economics instructors.  Suppose you have an advanced topics chapter at the end of macro 101, which covers the standard Phillips Curve (using inflation), and discusses the Natural Rate Hypothesis and the importance of expectations.  Would it be acceptable to have a section at the very end of that chapter with the final two graphs shown here?  I.e., the two AS/AD graphs to show students the downside of using inflation as an indicator of whether the economy is overheating, and the NGDP version of the Phillips Curve to explain to students why more and more economists favor NGDP targeting.

Or is there something I am missing, which makes NGDP unsuitable for the vertical axis of a Phillips Curve?

PS.  The principles textbook I’m working on will be ready for consideration later this year, available for use in classes in the fall of 2019.


Do demographics explain disinflation?

No they don’t; monetary policy determines the rate of inflation.  But the Wall Street Journal’s “Daily Shot” sees things differently:

Over the long run, economists think that demographics dictate inflation trends. The collapsing US labor force growth is expected to be a drag on the CPI.

Really?  I’ve never met an economist who thinks demographics determine inflation.  Now let’s look at the graph the WSJ uses to back up this claim:

People are far too impressed by this sort of simple correlation.  Let’s look at what the statistician had to do in order to make labor force growth and inflation look correlated:

1.  The scales for the two lines are completely different.  The left scale shows labor force growth, and tops out at 2.8%.  The right scale shows inflation, and tops out at nearly 9%.

2.  Both graphs use 10 year moving averages, which smooths out a lot of the short term volatility.

3.  The civilian labor force graph uses a 4 year lead, to make the peak growth rate line up with the peak inflation rate.

If the data were any further massaged it would turn into a bloody pulp.

Here’s what people often do.  They find two time series that each have a long period of upswing, followed by a long period of downswing.  They could have just as well have used interest rates, or some other variable.  But they chose inflation and labor force growth.  Then they smooth the data, adjust the two scales so that each peak has the same height, then use leads or lags to make the peaks line up on the horizontal axis as well.

Even worse, they use two series that are not linked according to any economic theory that I am aware of.

This is too sloppy to get published in an academic journal.  But the stuff that does get published is often flawed in a similar way, just to a much lesser extent.  The errors are more subtle.

PS.  Check out US labor force growth rate from 1865-96 (high).  Then check out the rate of inflation (negative).

HT:  Daniel Griswold

Why is inflation so low?

I have a new piece on low inflation in US News and World Report:

Surprisingly, the recent undershoot of inflation had occurred during a period when the Fed has been raising interest rates, a policy that is normally aimed at slowing, not increasing, inflation. It’s as if a ship captain responded to persistent headwinds by turning the rudder in the wrong direction.

Off topic, a couple National Review pieces caught my attention:

In Rome in 1973, a grandson of the richest man in the world, J. Paul Getty, was kidnapped. In All the Money in the World, director Ridley Scott’s bizarre take on this story, Getty is the villain, while the kidnappers are simply dutiful professionals tasked with carrying out their unfortunate mission as best they can despite Getty’s intransigence about paying them ransom.

They don’t use the term ‘nepotism’, but that’s what this is all about.  Nepotism is frowned on in the US and Northern Europe; indeed favoring your relatives at the expense of society is viewed as completely unethical.  In most of the world things are exactly the opposite; it’s viewed as unethical not to favor the well being of one’s grandchildren over the best interest of society.

I doubt that many Sicilians would agree with me, but my utilitarian value system forces me to view Getty as a hero, not a villain.  The world would be a better place if everyone viewed things as I do, and no one paid ransom to kidnappers.  (That doesn’t mean I’d refuse to pay ransom, just that I’d be a hero if I did.  I never claimed that I’m a hero.)

Hollywood often promotes utilitarian values, but this is less true in the case of economic issues.  In those cases, Hollywood focuses on the “seen”, not the “unseen”.

Here’s the excellent Ramesh Ponnuru in the National Review:

Many Republicans credit Trump for presiding over a strong economy, too. It’s a point that requires some context. Job growth has not been quite as fast as it was in Obama’s last year, but you’d expect it to slow after an expansion this long.

That’s a defensible argument, but only if you assume that the entire alt-right/Trump campaign was built on a pack of lies.  Recall the economic “carnage” that Trump referred to in his inaugural address.  Recall the claims of 30% to 40% unemployment.  Recall the claims that downtrodden unemployed workers in West Virginia, Wisconsin, Pennsylvania and Michigan voted for Trump out of desperation.

So yes, it’s possible that job growth slowed in 2017 because Obama left Trump with an American job market that was already “Great Again.”  I’m not going to take a position either way on this issue; just point out that Trumpistas can’t have it both ways.

US News has a new article pointing out that the legalization of pot in Colorado did not lead to the total disaster predicted by drug warriors:

Over at Econlog I have a recent post discussing Portugal, which has decriminalized the use of all drugs.  Heroin addiction has fallen sharply, again just the opposite of what the drug warriors predicted.

I’d have a tad more respect for conservative Republicans like Jeff Sessions if they spent less time gloating over tax cuts for corporations, and instead expressed a bit of remorse over the millions of lives they have ruined with their punitive policies.  Policies that we now know were ineffective.  Here’s one example from Reason magazine:

About a year later she was picked up in another undercover sting.  This time, having turned 18, she was arrested for prostitution (a misdemeanor) and possessing a small quantity of marijuana (a felony).  The conviction shattered her dreams of someday becoming a nurse.

Now, she says, “I’m a single mother with a felony and I will be labeled a loser and a whore for the rest of my life.”  Mere months ago, she was being exploited.  Today, for the same behavior, she’s a criminal.

HT:  Ben Cole

Is Christmas even merrier than in 1967?

This graph in the FT caught my eye:

The graph shows two measures of the rate of increase in the “cost of living” in China.  The blue line is the government CPI, while the red line shows the results of public opinion surveys.

At first glance they look pretty similar, but check out the two scales.  Chinese CPI inflation has been running at about 2% in recent years, while the public’s estimate of inflation is around 6%.  The gap was even bigger in the (booming) early 2010s.  So what’s going on here?

This is just one more illustration of my claim that inflation is a pretty meaningless concept.  To economists, it’s the increase in the price of a bundle of goods, adjusted for quality changes.  To the public, it’s the increase in the cost of “living the way we live now.”

Thus if a nice flat panel TV cost $600 today, and a nice black and white TV cost $300 back in 1967, then the public would say that the TV part of the cost of living has doubled, while economists would say that the price of TVs has plunged by something like 90%, because the quality improvements have been so massive.

[In 1967, I frequently had to shake the antenna on top of our TV set, to prevent constant flickering and “snow”.  I didn’t even know that the Wizard of Oz was a color film until I saw it in the theatre at age 35.)

Alternatively, the public would say that Christmas today is about equally merry as in 1967, while economists would say that today’s Christmas is far merrier due to technological progress.

Here’s my take on the Chinese data.  The top line is strongly correlated with growth in NGDP per capita, i.e. average income.  If Chinese living standards are rising rapidly each year, then this factors into what people feel they need to earn to “keep up with the Zhangs”.  They are interested in knowing how much it costs to have a middle class Chinese lifestyle.  Indeed this concept may be even more important in “communist” China than in supposedly materialistic America.

On closer inspection, however, the rise in the perceived Chinese cost of living is a bit less that the rise in NGDP.  And I think that’s due to lifecycle effects.  Thus the older Chinese don’t need all the fancy new gadgets that millennials buy, and hence their cost of living rises a bit less rapidly than the overall rise in NGDP/person.

I’d expect that surveys of American perceptions of inflation would show something similar; a subjective inflation rate that is above the official CPI, but below the growth rate of NGDP/person.  Does anyone know of such a survey?

PS.  The FT article says the Chinese economy is accelerating into 2018.  It looks like those who predicted that the Chinese “bubble” would burst will be wrong for the 40th year in a row.  Indeed 2018 looks like a relatively strong year for the entire global economy.

PPS.  Check out the new Tianjin library:

Merry Christmas and a Happy New Year to all my readers.


Further thoughts on NeoFisherism

David Beckworth recently interviewed Stephen Williamson, who is an advocate of the NeoFisherian approach to thinking about monetary policy and interest rates.  Williamson argues that a policy of permanently reducing interest rates is disinflationary.  Others think this idea is crazy.  I’m not in either camp, and I keep looking for ways to explain why.  Here are some facts about monetary policy, which seem related to this issue:

1. In the short run, nominal interest rates can be reduced with a tight money policy.

2. In the short run, nominal interest rates are usually reduced with an easy money policy.

3. Because money is neutral in the long run, any monetary policy that permanently reduces nominal interest rates must be disinflationary.

4. A tight money policy reduces the natural rate of interest.

All of these claims are pretty easy to justify, and none seem particularly controversial.  But they raise an interesting puzzle.  Points #1, #3 and #4 all seem sort of NeoFisherian in spirit, consistent with the claims made by Stephen Williamson and John Cochrane.  So why are so many mainstream economists horrified by NeoFisherism?  I think the sticking point is #2.

The vast majority of the time, a reduction in interest rates on any given day represents an easier monetary policy than a counterfactual policy where the central bank doesn’t reduce interest rates.  Not always (in which case #1 and #3 would no longer be true), but the vast majority of the time.  But the NeoFisherian thought experiment requires that the lower rates be achieved via tighter monetary policy.

I think that people are confused about what NeoFisherians are talking about when they discuss policy option number three.  In the minds of most economists, switching to a permanently lower interest rate seems like an expansionary monetary policy, because on any given day cutting interest rates usually is an expansionary monetary policy.  Here’s why they are wrong:

1. If you don’t want the price level to blow up, then any permanent switch to a lower interest rate must be done with a tighter monetary policy.  If the central bank tried to do it with an easier money policy then they’d have to inject larger and larger amounts of liquidity, eventually causing hyperinflation and then complete collapse of the system.  So any sustainable policy of low interest rates must be contractionary.

2.  A contractionary monetary policy lowers the natural rate of interest.  I think many economists picture a world where the natural rate of interest is not affected by monetary policy.  In that world, lowering the policy rate makes policy more expansionary, because the stance of monetary policy is the gap between the policy rate and the natural rate (assumed to be stable).  In fact, any sustainable policy of low rates must be caused by tight money, and any tight money policy will reduce the natural rate of interest so much that monetary policy does not get easier, despite the lower fed funds target.  This is Japan since 1995.

So far I’ve presented a picture that is somewhat sympathetic to the NeoFisherians.  Let me conclude with a discussion of what I don’t like about the way NeoFisherians present their theory.

1.  The listener is led to believe that if you want lower inflation, you need to cut interest rates.  I’d say if you want lower inflation you need to cut interest rates via a tight money policy.  Any attempt to achieve lower inflation via a cut in interest rates achieved through an easier money policy will end in disaster.

2.  Because the vast majority of rate cuts represent easier money than the counterfactual of not cutting rates on that given day, it is not accurate to imply that the first step to lowering inflation is for the central bank to do the sort of rate cut that it often does do–i.e., liquidity injections.  Instead, the NeoFisherians should argue that the first step to lower inflation is for central banks to do the sort of rate cut that the Swiss National Bank did in January 2015, when they simultaneously appreciated their currency and created a credible policy of further currency appreciation going forward.  That credible promise led to lower nominal interest rates via the interest parity condition, and lower inflation expectations via the currency appreciation (combined with PPP.)

PS.  Has anyone commented on the similarity between the NeoFisherian puzzle identified in points #1 – #4 above, and the puzzle that led to the Dornbusch overshooting model?  The overshooting model was an attempt to resolved the following puzzle in a conventional Keynesian fashion:

Puzzle:  Easy money seems to lead to both actual currency depreciation and expected currency appreciation.

Rudi Dornbusch wanted to show how easier money could lead to expected currency appreciation (which is an implication of lower nominal interest rates combined with the interest parity condition.)  His solution was overshooting.

The NeoFisherian model assumes a permanent change in the interest rate, which rules out Dornbusch’s resolution to this puzzle. If you make the rate cut permanent than his solution no longer works; you take overshooting off the table.  In that case, the NeoFisherian result is the only explanation left standing.  Now it is a tighter money policy that reduces interest rates, and that tighter money also makes the currency become expected to appreciate forever, lowering inflation.