The problem with procyclical inflation

Here’s Charles Evans in the WSJ:

“We’ve averaged well under that 2% mark for the past six-and-a-half years,” Mr. Evans said. “With a symmetric inflation target, one could imagine moderately above-target inflation for a limited time as simply the flip side of our recent inflation experience-and hardly an event that would impose great costs on the economy.”

There’s no doubt in my mind that a policy of letting inflation run a bit above target during the next boom will not cause great hardship during the next boom

But a policy of running inflation below target when unemployment is high and above target when it is low makes the business cycle much worse, and does impose great hardship.  Some conclusions:

1.  A procyclical inflation policy violates the dual mandate.

2.  NGDP targeting would lead to countercyclical inflation (a good thing).  As Nick Rowe likes to say, you want to make it so that the public’s stupid belief that inflation is bad . . . is true.  Good supply-side policies would become anti-inflation policies.

3.  Discussions of “what should the Fed do now?” are meaningless and incoherent, unless embedded in a clearly specified long run policy regime, as are discussions of whether QE “increases inequality.”

Charles Evans is actually one of the best people at the Fed.  Then there is the other Charles:

Federal Reserve Bank of Philadelphia President Charles Plosser said Friday that inflation levels that have fallen persistently short of where the central bank wants them to be are not a significant issue to him right now.

It’s true that inflation levels are “a little bit low” relative to the Fed’s desire to have price pressures hit 2%, Mr. Plosser said at an appearance in New York. But, “for the most part, I’m not too concerned about that,” he said.

What he doesn’t say is that the reason the Fed has failed is partly due to the fact that he’s consistently been pressuring them to be more contractionary, even as they were already far too contractionary to hit their dual mandate. So Plosser’s telling us that the Fed is not doing its job, partly due to his consistently bad advice, but he doesn’t much care.

Fortunately, market monetarist ideas are gradually seeping into the media.  A few days ago we saw this at the Financial Times, now it’s Bloomberg’s turn:

Based on the gap between yields of government notes and TIPS, traders have scaled back estimates for average inflation through 2019 by a half-percentage point since June to 1.52 percent, Fed data compiled by Bloomberg show.

.  .  .

With the Fed’s preferred measure averaging 0.34 percentage point less than CPI in that span, traders are signaling prices based on that gauge may rise as little as 1.18 percent. Through August, the personal consumption expenditures deflator has fallen short of the Fed’s 2 percent goal for 28 straight months.

Fed officials “need to be paying attention to that because there’s a collective wisdom element to the TIPS market,” Mitchell Stapley, the chief investment officer for Cincinnati-based ClearArc Capital, which manages $7 billion, said in an Oct. 8 telephone interview.


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26 Responses to “The problem with procyclical inflation”

  1. Gravatar of benjamin cole benjamin cole
    24. October 2014 at 23:44

    If you are going to have an inflation target, the worst time possible to undershoot the target is in the worst recession since WW2.

    The Fed followed SOP—standard operating procedure—and used the 2008 collapse to ratchet down inflation rates, as it has done in every recession since 1980.

    Charles Plosser regards this as a great success.

  2. Gravatar of Brian Donohue Brian Donohue
    24. October 2014 at 23:52

    TIPS represent an excellent source of information. Even if the NGDP futures market doesn’t take off, it seems like the Fed gets excellent feedback from the TIPS market. Use it please.

  3. Gravatar of Michael Byrnes Michael Byrnes
    25. October 2014 at 04:15

    Is Evans advocating a procyclical inflation policy or is his comment a nod towards level targeting? Or both?

  4. Gravatar of ssumner ssumner
    25. October 2014 at 04:19

    Michael, I wondered about that too. But the problem is that the Fed has not been doing level targeting. And the public doesn’t believe they are doing level targeting, which eliminates much of the beneficial effect of actually doing level targeting.

  5. Gravatar of Major.Freedom Major.Freedom
    25. October 2014 at 05:12

    This socialist “target” is not a market driven, coherent standard. There is nothing in social cooperation whereby a specific socialist “target” can be scientifically established as the standard by which “above target” or “below target” given rates of unemployment either “makes things worse” or “makes things better”.

    The “good” is not government determined. The “good” is not a central plan. The “good” is not any socialist rule of government currency printing.

    The “good” is only what the individual creates for him or herself. If the individual’s person or property is subjected to initiations of force, which it is in the case of socialist money enforcement, then the “good” is destroyed, and the “bad” reigns supreme.

    What socialist monetarists consider an off target cause “hardships” applies their false conception of the on target good.

    Merely having a socialist target doesn’t mean you have found a non-harship causing central plan. It is the central planning itself that is the problem.

    The belief that inflation is bad is not only not stupid, but it is the opposite position that is stupid. Stupidity is believing in a magical “essence” of unique individuals.

  6. Gravatar of bill bill
    25. October 2014 at 05:25

    The Fed has undershot its own target for 28 straight months. So of course the right thing to do is to tighten (taper and end QE).

  7. Gravatar of Edward Edward
    25. October 2014 at 07:30

    Major freedom continues his word salad. He’s like an annoying dog that won’t stop barking

  8. Gravatar of TravisV TravisV
    25. October 2014 at 08:59

    Awful confusion in Germany. The latest:

    http://www.reuters.com/article/2014/10/23/us-ecb-germany-insight-idUSKCN0IC1TJ20141023

    “Mario Draghi’s German problem”

  9. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    25. October 2014 at 09:51

    Maybe the Market Monetarists should get on this bandwagon;

    http://www.voxeu.org/article/monetary-policy-and-inequality-us

    ‘While there are several conflicting channels through which monetary policy may affect the allocation of wealth, income, and consumption, our results suggest that, at least in the US between 1980 and 2008, contractionary monetary policy actions tended to raise economic inequality or, equivalently, expansionary monetary policy lowered economic inequality.’

  10. Gravatar of benjamin cole benjamin cole
    25. October 2014 at 15:32

    Patrick Sullivan – – you may have struck upon the reason the right wing is so shrill and even bellicose in its calls for tight money and zero inflation.

  11. Gravatar of mikef mikef
    25. October 2014 at 15:42

    Can you explain what happens when you have supply shocks that suddenly create deflation. This should be unambiguous good for the economy. So the recent decline of the price of oil is primarily caused by greater supply (Libya and US fracking) and lower demand. The lower demand is partially due to macroeconomic issues, but also due to greater efficiencies (higher productivity) and by product substitution (natural gas, electric).

    There may be some increases in RGDP, but doubtful that it would make up for drop in inflation and therefore NGDP is reduced. So if we are targeting NGDP, we will try to offset this by creating more money induced inflation. But does this really make sense. Yes, some drillers are not making as much but overall most employers are feeling an unexpected windfall and do not feel the need to lower wages. So the issue of sticky wages should not be an issue. They could be passing some of this windfall to consumers, employees, or shareholders depending on their situation. So if inflation is below target because of supply shocks, is this really a problem?

  12. Gravatar of maynardGkeynes maynardGkeynes
    25. October 2014 at 15:43

    Is everyone here convinced that the Fed could achieve a substantially higher level of inflation, assuming it wanted to? It’s really just an question: If they can’t get to 2%, and I really do think they want to (because they now look pretty inept) — what makes you think they have the wherewithal to go to 3%, 4% or 5%?

  13. Gravatar of TravisV TravisV
    25. October 2014 at 17:07

    Benjamin Cole,

    I wish the explanation were as simple as that but of course it isn’t. :)

  14. Gravatar of Major.Freedom Major.Freedom
    25. October 2014 at 17:25

    Edward,

    Then you’re someone who cannot even refute a dog.

    U mad bro?

  15. Gravatar of Dan W. Dan W.
    25. October 2014 at 17:55

    In defense of QE:

    “Monetary authorities always dance on the head of a pin in this way, trying to balance all of these inputs and avoid catastrophe. It’s a difficult task.”

    http://www.powerlineblog.com/archives/2014/10/in-defense-of-qe.php

    Maybe the task is not just difficult, but impossible. Yet as long as the bankers believe a credit system based on fractional-lending is linear they can claim everything is under their control.

  16. Gravatar of Don Geddis Don Geddis
    25. October 2014 at 18:20

    @maynardGkeynes: Yes, the Fed could inflate if it wanted. The obvious answer to your question, is that you think they really do want to get to 2% (and are failing), whereas we think they have rationalized the current state of the economy. (Why else all the talk about the taper? If you were really trying “everything you can” to reach 2%, how could tapering QE possibly help?)

    In any case, even I could do it. Make me King of the Fed, and the next day I announce the following new monetary policy: we will buy $10B bonds (QE) next month. If inflation remains below 2%, we will buy $20B the next month. Then $40B. Then $80B. Then $160B. The doubling of purchases will continue, until inflation rises above 2%.

    What prediction would you make, from the day such a policy is announced, how many days it would take before inflation is, in fact, over 2%? (Extra credit: what quantity of bonds do you think will have actually been purchased, before the 2% threshold is crossed?)

  17. Gravatar of Scott Sumner Scott Sumner
    25. October 2014 at 18:34

    TravisV, What’s so odd about the German article is that even Draghi’s policy is producing inflation way too low to hit their target. Precisely what inflation rate do the German’s want, and how do they intend to get there?

    mikef, Those are good points. It may be a bit of both, with the part that is lower global AD explaining the stock price decline. But the US economy still looks OK to me. At least relative to the others.

    Maynard, Obviously it’s not because they are out of ammo, they are tightening precisely because they worry about the US economy overheating. If they had problems raising inflation they certainly would not be tightening now.

  18. Gravatar of maynardGkeynes maynardGkeynes
    25. October 2014 at 19:34

    @Don Geddis: “What prediction would you make, from the day such a policy is announced, how many days it would take before inflation is, in fact, over 2%? (Extra credit: what quantity of bonds do you think will have actually been purchased, before the 2% threshold is crossed?)”

    I think one plausible answer, based on what we have seen so far, is “never” on inflation going (much) above 2%, and the Dow at 360,000. What is the transmission mechanism for inflation when wages are effectively frozen for 98% – 99% of the labor force?

  19. Gravatar of TravisV TravisV
    25. October 2014 at 19:35

    Prof. Sumner,

    I’m curious how QE came to be seen as so much more evil among the German public than it is among the American public.

    At any rate, here’s the latest news I’ve seen on Merkel / ECB:

    http://www.bloomberg.com/news/print/2014-10-25/merkel-changes-tone-as-she-hints-at-euro-area-investment-needs.html

    “Merkel Changes Tone as She Hints at Euro-Area Investment Needs”

  20. Gravatar of ssumner ssumner
    26. October 2014 at 04:28

    TravisV, If only she’d change her mind on monetary policy, not fiscal policy.

  21. Gravatar of Don Geddis Don Geddis
    26. October 2014 at 07:51

    @maynardGkeynes: well, I don’t believe you, that money supply growth would somehow only raise stock market prices, without affecting prices in the rest of the economy. But even if that were true, how could that possibly be a stable economy? People who owned even tiny amounts of stock today, would suddenly find that their assets were worth huge amounts, and dominated their net worth. You don’t think, once in awhile, they might sell just a few shares, and … I don’t know … maybe buy a car, or go on vacation, or eat out at a restaurant? (And maybe wealthy people would buy houses, and airplanes, and sports teams…) They’re just going to keep working low-paying jobs, scrimping on consumption, while they own stock assets worth many times their annual salary, but for some reason choose never to sell any stock?

    Your scenario doesn’t sound plausible.

  22. Gravatar of Major.Freedom Major.Freedom
    26. October 2014 at 08:57

    “I don’t believe you, that money supply growth would somehow only raise stock market prices, without affecting prices in the rest of the economy. But even if that were true, how could that possibly be a stable economy?”

    Welcome to the business cycle. Glad you’ve finally clued in.

    One small correction: it is not that inflation affects only stock prices. It is that inflation can and does affect stock prices by more than prices in the rest of the economy. But each cycle is unique. Not unique in the sense that if we had a cycle of stock prices rising more than other prices that this will never happen again, but rather they are unique in that we can never know a priori exactly which prices will be affected by inflation more so than other prices.

    It is reasonable to believe that inflation since 2008 has affected stock and bond prices (upwards) significantly more than prices in the rest of the economy.

    Yes, this is unstable, but not because of the differences in price changes per se, but rather because of the unsustainable real activity that results from investors allocating capital and labor in accordance with this disjointed price changes caused by the inflation rather than actual consumer preference changes.

    Resources are scarce, even when there is “slack”, and the temporal allocation of resources must be in line with the consumer’s temporal preferences, or else something’s got to give.

    Inflation is heterogeneous. If a central bank targets NGDP, that doesn’t mean all individual spending and individual prices rise at the same time along with the NGDP percentage change. A rising NGDP is entirely consistent with an unstable disjointed price and spending allocation, which takes place because investors don’t know where to allocate capital and labor in line with consumer preferences. With central banks overruling consumer preferences, investors can only observe prices that are a function of both consumer preferences and central bank preferences, and central bankers can never know a world without their actions affecting it, but it is precisely that world that investors need to know how to properly allocate capital and labor.

  23. Gravatar of Don Geddis Don Geddis
    26. October 2014 at 09:57

    Ah, MF/Geoff. Once again, the master of irrelevancy, and word salad walls of text. You don’t know what people are talking about, but you never miss an opportunity to press “play” on your tape recorder of a lecture.

    I know you don’t care, but the context was that maynardGkeynes had asked “[could] the Fed achieve a substantially higher level of inflation, assuming it wanted to?” Your reply, as usual, was completely irrelevant to the question being discussed.

  24. Gravatar of Major.Freedom Major.Freedom
    26. October 2014 at 17:37

    Don’t Geddis:

    “Ah, MF/Geoff. Once again, the master of irrelevancy, and word salad walls of text. You don’t know what people are talking about, but you never miss an opportunity to press “play” on your tape recorder of a lecture.”

    I know what you are taking about. It is how I know you’re wrong, lol.

    “I know you don’t care, but the context was that maynardGkeynes had asked “[could] the Fed achieve a substantially higher level of inflation, assuming it wanted to?”

    I do care. That question was too easy to spend time on it. But to indulge you, the Fed could achieve any level of inflation it wanted, except that which would result in an outright rejection of the currency. Whatever that level is, would depend on the circumstances at the time.

    “Your reply, as usual, was completely irrelevant…”

    It was relevant. It was an answer your question regarding stability.

    I just gave you an answer you didn’t like.

  25. Gravatar of Major.Freedom Major.Freedom
    26. October 2014 at 18:07

    My tablet auto corrected to “Don’t Geddis”. Didn’t notice until after posting.

  26. Gravatar of Brian Donohue Brian Donohue
    27. October 2014 at 05:07

    @TravisV, perhaps Germany is vexed because they went through hard structural reforms (2004 Haartz) and perceive that those without Teutonic resolve should be made to walk through the same door. I think it’s shortsighted, but…

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