I almost always agree with Paul Krugman’s views on inflation.  We’ve both been skeptical of claims that US monetary and fiscal policy will produce high inflation.  Krugman points to the economic slack in the economy, I focus on TIPS spreads.    In a recent post, Krugman made the following observation:

. . . if we think of wages as the ultimate core price, I don’t see any mechanism in today’s America whereby rising commodity prices translate into higher wage contracts.

But what does the historical record say? It depends on which era you’re looking at.  . . .

The two big commodity price shocks of the 70s did, in fact, feed quickly into core inflation. Since then, however, nada.

Why the difference? The obvious point is that back in the 70s many labor contracts included cost of living adjustments (COLAs). This in turn partly reflected stronger worker bargaining positions and also real doubts about whether monetary policy would contain inflation. Today, none of that: COLAs are rare, and commodity-price fluctuations don’t feed into wages at all.

My only observation here is that we don’t even need to bring COLAs into the picture.  Wages respond to trend NGDP growth, and those growth rates were extremely high during the 1970s, even during recession years.  For instance, NGDP grew at an 11% rate between 1971:4 and 1979:4, and then grew another 9.6% in 1980, despite a mild recession.  Since monetary policy determines the trend rate of NGDP growth, this analysis is consistent with Krugman’s observation that in the 1970s there were “real doubts about whether monetary policy would contain inflation.”  But the phrase “contain inflation” is a tad misleading—suggesting that inflation was like a wild animal on the loose and needed to be reined in by the Fed.  The Fed caused the Great Inflation.

As you know, I often say “never reason from a price change.”  I think we’d be better off talking about the impact of NGDP on wages, which is fairly stable, rather than the impact of prices on wages, which is highly dependent on whether prices are rising because of more demand, or because of supply-shocks.  As we saw in mid-2008, high headline inflation doesn’t translate into big pay increases if not associated with fast NGDP growth.  The Economist made a similar observation for Britain:

But a jump in inflation caused by higher commodity prices and a rise in VAT””in an economy with spare capacity””is quite different from one caused by excess demand and a pay-price spiral. It intensifies the squeeze on households from other tax rises and curbs consumer spending.  Although the central bank is facing calls to tighten monetary policy soon, that would be warranted only if there were signs of inflation getting embedded into expectations and feeding through to higher wages.

Unsurprisingly, households are now expecting inflation to be higher over the coming year. But other official figures published this week showed no sign of a pay-price spiral. Average earnings are rising by just 2.1%, a very muted rate by historical standards. It is difficult to envisage wages taking off when the public sector is shedding jobs and facing a two-year pay freeze and there are 2.5m people unemployed, close to 8% of the labour force. Indeed the youth-unemployment rate has reached 20.3%, the highest since comparable records began in 1992.

The economy clearly retains quite a bit of spare capacity””the main reason why the Bank of England has insisted that the flare-up in inflation will be temporary. The bank has lost credibility as the inflation overshoot has persisted and its forecasts have proved incorrect.

[there was a rogue paragraph in the original version, which I deleted]

Keynesians often focus on economic slack as a determinant of wage gains.   That’s a bit too simple (as we saw in the 1970s); the more sophisticated Keynesian models now account for expected inflation.  And in fairness, the “slack” model of wages does seem to outperform the NGDP growth rate model during recoveries, when wage gains are often quite moderate, despite fast NGDP growth.

But there’s a good reason why wage gains often trail NGDP growth during a recovery—wage cuts trail declines in NGDP during most contractions.  Thus wages are still adjusting to the previous drop in AD during the early stages of a recovery.  The Keynesian model is good at explaining cyclical variations in wages, but not so good at explaining long run changes in trend wage growth, and trend NGDP growth.  For that you need the quantity of money.

Britain is facing an interesting dilemma.  The BOE clearly understands that NGDP, not prices, are the best indicator of demand.  They understand that it would be a mistake to react to the 3.7% headline inflation in December (yoy), by tightening monetary policy.  But they are constrained by the fact that almost everyone (wrongly) thinks it’s the central bank’s job to control inflation.

In contrast, fiscal policy is almost always evaluated in terms of real GDP growth.  This dichotomy makes no sense.  There is no macro model of any school of thought that says monetary policy controls inflation by shifting demand, and fiscal policy controls RGDP by shifting demand.  Yet when RGDP growth in Britain came in at a disappointing minus 0.5% in Q4, almost all the reports pointed not to the BOE, but to the fiscal austerity of the new British government. Even Brad DeLong, who devoted much of his talk at the recent AEA meetings to emphasizing the importance of NGDP, quotes an article giving a RGDP number for Britain.  RGDP numbers tell us nothing about whether demand stimulus is succeeding.  In fairness, I believe the UK NGDP numbers come out with a lag, but the problem is much deeper than that.  The media overwhelmingly sees fiscal policy as a RGDP issue and monetary policy as an inflation issue.  Until both are seen as NGDP issues we will not be able to come up with coherent policy regimes, which assign fiscal and monetary policy their appropriate roles.

There are two ways British policy might fail.  First, the BOE might fail to hit its implicit NGDP target.  Why would that occur?  Not because Britain is in a liquidity trap.  They are actually expected to tighten policy this summer.  And Britain can always depreciate its currency if it wants to.  It could even cut rates another quarter point.  No, with 3.7% inflation it’s madness to even talk about liquidity traps.  If they fail it will be because fear of politically embarrassing headline inflation numbers caused BOE officials to take their eye off the ball (NGDP.)  However if BOE policy does fail to boost NGDP, I predict fiscal austerity will be blamed.

Alternatively, policy might fail because the Gordon Brown government did significant damage to the supply-side of the UK economy, by increasing the size of the state.  A supply-side failure would show up as stagflation, i.e. appropriate NGDP growth but high inflation and slow RGDP growth.  Although we saw a bit of stagflation in the 4th quarter, it’s too soon to draw any conclusions.  Inflation will probably slow over the next few years.

I predict that if policy does fail for supply-side reasons, the failure will be widely attributed to demand-side factors, especially fiscal austerity.  That’s because everyone focuses on RGDP, and almost no one pays any attention to NGDP.

It’s easy to find a correlation between two macro variables, as the same sort of factors (inflation, output growth, interest rates) tend to affect all sorts of financial and macro variables.  For that reason, one of the most useful statistical tools is time-varying correlations.

For example, when I studied the Great Depression I recall reading a year end summary of the 1931 stock market in the New York Times.  They summarized the US stock market month by month, and mentioned German problems in all the summaries of the last 7 months, but none of the first 5 months.  And sure enough, during the last half of 1931 the price of German war bonds was highly correlated with US stock prices.

But how can one prove cause and effect?  Lots of things might have affected both German war bond prices, and US stock prices.  For example, signs of a strong economic recovery worldwide might boost the value of both assets.  On the other hand, if German problems were depressing US equity markets, then you’d expect a strong correlation between German war bond prices and US equity prices during periods when there were lots of problems in Germany (late 1931), but essentially no correlation during periods when German problems were not particularly significant (early 1931.)  And that’s exactly what I found.  Or to take another example, Steve Silver and I found that US industrial production became negatively correlated with nominal wages after 1933, precisely when New Deal programs began to artificially raise nominal wages.

Almost a year ago David Glasner mentioned that he was working on a similar study, this time estimating the time-varying correlation between US inflation expectations and US equity prices.  He has frequently sent me very significant results, but I held back from mentioning them in order to let him get the project completed before publicizing the results.  He has now placed the paper at the SSRN web site, where others can read it.  In the meantime I notice that others have observed this pattern, indeed the commenter Gregor Bush recently mentioned some similar results.

It is well known that there is normally little correlation between US inflation expectations and US stock prices.  Higher inflation might boost stock prices if associated with growing aggregate demand, but higher inflation can also lead to expectations of tight money, or higher taxes on capital, since capital income is not indexed.  Indeed the high inflation of the 1970s seems to have depressed real stock and bond prices.  In general, the stock market seems content with the low and stable inflation of recent decades, at least judging by reactions to changes in inflation expectations.

David looked at 8 years of data, from January 2003 until December 2010, and divided the sample up into 10 sub-periods.  He found almost no significant correlation between inflation expectations (TIPS spreads) and stock prices (S&P 500) until March 2008.  (Actually, there was a modest positive correlation during the first half of 2003, another period when people worried about excessively low inflation.)  After March 2008, the correlation was highly significant, and positive.  Right about the time where the US began suffering from a severe AD shortfall, the stock market began rooting strongly for higher inflation.  And it still is, even in the most recent period.  Money is still too tight.

There is no way to overstate the importance of these these findings.  The obvious explanation (and indeed the only explanation I can think of) is that low inflation was not a major problem before mid-2008, but has since become a big problem.  Bernanke’s right and the hawks at the Fed are wrong.

Arnold Kling noted that the AS/AD approach can sometimes verge on the tautological.  When inflation and output both fall, demand-side economists are likely to infer that AD is lower.  And they are also likely to claim that the fall in AD caused both the drop in inflation and the drop in output.  Of course that’s not the only evidence demand-side economists have, but in many cases it’s hard to find definitive evidence of causation.

In my view the time-varying correlations between inflation expectations and stock prices are one of the most important pieces of evidence we have that AD became a problem after mid-2008.  It will be interesting to see if those economists who are skeptical of demand-side explanations can come up with a plausible alternative explanation for this pattern.

PS.  If anyone knows how to estimate a continuous time-varying correlation, it would be interesting to find out precisely when in 2008 US equity markets started rooting for higher inflation.

PPS.  I’ve been asked to comment on the very weak performance of NGDP and the very strong performance in final sales during 2010:4.  If I had any confidence in the government numbers I would comment.  Let’s wait a few more quarters, look at lots of different data, and see where we are.  Again, my test of a policy is its effect on expected NGDP, not the actual movements in NGDP (which reflect all sorts of factors.)

.  .  .  that the Fed wants 2% inflation?

I was about to make fun of this quotation from Ryan Avent:

Meanwhile, the Fed got little to worry it on the inflation front. Its favoured inflation measure””the core price index for personal consumption expenditures””came in at a 0.4% annual growth rate. That measure has declined steadily from the fourth quarter of last year.

And then I thought to myself; don’t be a smart-ass.  I’ll bet most macroeconomists would read that without batting an eye.  Sure the Fed claims to want 2% inflation.  But if that were true then economists and reporters would say “increasingly bad news on the inflation front,” not good news.  The fact that they don’t means that at some level everyone understands the Fed wants more NGDP, and would prefer any increase in NGDP to be as much real growth and as little inflation as possible.  So why can’t we drop the pretence that they want 2% inflation, and start talking about NGDP?  Why can’t we say what we mean?

PS.  I’ll start being a smart-ass again in my next post—on Paul Krugman.

A few months back a great deal was made of a letter signed by 24 mostly conservative intellectuals.  Some people drew the conclusion that conservative economists were opposed to QE2.  Undoubtedly many are, including some that did not sign the letter.  But the letter itself shows almost nothing.  Many of the signers were not economists.  A grand total of 5 had jobs at American universities.  One more taught at a college.  Four were at Stanford, meaning a total of one American economist teaching at a university not named Stanford signed the letter.  Let’s take a look at that one, the distinguished monetary economist Charles Calomiris, who teaches at Columbia University.

Noah Kristula-Green emailed Calomiris to ask him why he opposed QE2:

Charles W. Calomiris of the Columbia University Graduate School of Business told FrumForum in an email that he favored keeping interest rates were they currently were:

“There are many reasonable alternative views on how to target monetary policy. I favor Ben McCallum’s proposal to target nominal GDP growth at about 5%. Since we were on track with that target before QE II, at least for the moment, I would neither be raising or lowering interest rates.”

Though he also stated that he would be in favor of a looser monetary policy if the evidence could convince him the circumstances warranted it:

“If there were evidence of a need for further loosening to raise the growth of nominal GDP to that target rate, then some quantitative easing might be a reasonable proposal.”

This puzzled me on several levels.  First, I also support 5% NGDP growth targeting, and I thought QE2 was far too weak.  The easiest way to explain this discrepancy is that I favor level targeting, which requires us to make up for at least some of the previous NGDP shortfall, whereas Calomiris may support a sort of “memory-less” growth rate targeting.  Let bygones be bygones.  I feel pretty strongly that level targeting is better after a serious slump, and also when monetary policy is up against the zero bound, but let’s put that issue aside.

What I find most perplexing about Calomiris’s statement is that even if you accept growth rate targeting, and even if you buy his argument that QE2 should only be adopted if there were signs that NGDP growth was likely to be inadequate, there is no logical reason why Charles Calomiris should have opposed QE2.

A few weeks ago I suggested that the early indications are that QE2 had raised NGDP growth expectations up from about 3.5% to 4.0% in late summer, to around 5.0% to 5.5% today.  Isn’t that what Calomiris wants?  But those were just my hunches, from reading various news stories.  So I looked for a table that averages the various forecasts.  The Economist  magazine provides monthly estimates of the consensus forecasts for RGDP and inflation.  They don’t provide separate NGDP forecasts, but NGDP growth is usually similar to the sum of RGDP growth plus CPI inflation, if not slightly lower (as the GDP accounts use a more conservative technique for estimating inflation.)

Here are the numbers for the last 8 months of The Economist:

Issue date     RGDP growth        CPI inflation    Sum of growth plus inflation

June 3                   3.0%                   1.8%                              4.8%

July 8                    2.9%                   1.5%                              4.4%

Aug. 5                   2.8%                    1.5%                             4.3%

Sept. 9                  2.4%                    1.5%                             3.9%

Oct.  7                  2.4%                     1.5%                             3.9%

Nov.  4                 2.3%                     1.5%                             3.8%

Dec.  9                  2.6%                     1.5%                             4.1%

Jan. 6                   3.0%                     1.5%                             4.5%

A few comments on the numbers.  The date refers to the issue of the Economist magazine.  Because these changes lag a couple months behind changes in many market indicators, my hunch is that the actual forecasts were made somewhat earlier.  The Economist may have surveyed forecasts that had already been published elsewhere by professional forecasters.  But either way, whether you think NGDP growth forecast hit bottom at the time QE2 was announced, or whether you believe (as I d0) that they hit bottom right before the intense flurry of QE2 rumors in September and October, it is clear that NGDP growth expectations were falling well below 5%, and QE2 seems to have raised them back up closer to Calomiris’s target.

I don’t know about you, but even if these numbers are slightly off, I don’t see any reason for someone who favors 5% NGDP targeting to write a highly public letter complaining about Fed policy on the basis of this sort of pattern.  Perhaps Calomiris looked at actual NGDP growth.  But NGDP growth had only averaged about 4% during the recovery, and if anything was slowing slightly in the summer of 2010.

Now it may be that actual NGDP growth in 2011 will come in at a tad more than 5%.  Perhaps we’ll get 4% RGDP growth and 1.8% inflation.  And Calomiris can claim that vindicates his opposition.  But even in that case I don’t think I’d write a letter complaining about Fed policy being too easy, particularly if I had not signed any letters complaining it was too tight from mid-2008 to mid-2009, when growth was 8% below trend, or mid-2009 to mid-2010 when it was 1% below trend.  Indeed I don’t recall any letters from conservatives complaining about tight money, unless you count us quasi-monetarists as “conservatives.”

My hunch is that Calomiris was asked to sign the letter, had recalled reading someone forecast roughly 3% growth, added on an assumption of 2% inflation, and thought “things are fine, we don’t need that.”  I think if he had looked closely at the data, and noticed that the recent increases in forecasts for 2011 occurred precisely when QE2 rumors began swirling around, and precisely because of QE2 rumors, he might not have signed the letter.  I hope he provides more clarifying remarks.

PS.  I notice Ben McCallum did not sign the letter.

The Fed releases minutes of their meetings with just a few weeks delay.  But the full transcript is kept secret for “an extended period” to insure more candor in the discussions.  Matt Yglesias recently suggested I look at the recently released FOMC transcript from February 2005, which contains an extended discussion of the pros and cons of inflation targeting.  There’s a lot of interesting stuff:

1.  There is pretty general agreement about the Fed’s long term inflation objective.  They’d like to see about 1% actual inflation.  Because they believe the PCE overstates inflation by 0.5% and the CPI overstates inflation by about 1.0%, they’d like to see about 1.5% PCE inflation or 2.0% CPI inflation.  I was quite surprised by the uniformity of views on this issue.  I don’t recall anyone who put forward a different number, just a few who discussed the advantages of ranges (1% to 3%) rather that point targets.

2. The committee does not favor a hard inflation target.  About half the members (led by Bernanke) favor giving the public a specific quasi-official number as a sort of goal, with the understanding that the Fed might have to deviate in the short run due to financial crises and/or supply shocks.  Other readers might disagree with this characterization, as they danced around the issue in a very tentative way, knowing it was actually Congress’s prerogative to set any formal policy goal.  The FOMC was obviously a bit distrustful of having Congress get heavily involved in monetary policy.

3.  I now feel much more confident in asserting that the Fed’s implicit target is 1.5% PCE and 2.0% CPI inflation.  Period.

4.  They also clearly indicated that a higher than 2% inflation rate might be appropriate under one of two conditions:

a.  Financial crisis

b.  Adverse supply shock

And they clearly acted on that belief in 2007 and 2008 when they cut the Fed funds rate during the sub-prime crisis, despite above 2% inflation.  However, I think they may have tragically misunderstood the implications of their supply shock arguments, and that’s the issue I’d like to focus on.  Consider the following quotation from Cathy Minehan.

So my policy preference for a given level or path of inflation would not be identical all the time. It would depend on what is happening in the real economy, just as in the first half of 2004 we tolerated rather rapid price growth on the basis of our calculation of the degree of excess capacity in the real economy and the temporary nature of the energy price increases. I know that over the long run there’s no tradeoff between growth and inflation and that price stability, however defined, is the best contribution monetary policy can make to economic prospects. But in the short run, when supply shocks can dominate, there can be  tradeoffs.

She is saying that if unemployment is sort of high, say 7%, and inflation was 3% due to energy price increases, you would not try to immediately bring inflation down to 2% if it meant pushing unemployment up to 9%.  And I am pretty sure that everyone at the Fed agrees with that.  However the inescapable implication of the argument is that if you have 9% unemployment and 2% inflation, you’d be better off pushing inflation up to 3% if it would reduce unemployment down to 7%.  The argument is completely symmetrical.

I saw no signs that the Fed understood this implication in 2005, and I still don’t.  Indeed when Brad DeLong asked Bernanke in 2009 why they don’t raise their inflation target to 3% to boost growth, Bernanke said it would be a very bad idea.

The problem here is that either there is a dual mandate, or there isn’t.  If there is, then the Fed would want to allow slightly higher than 2% inflation during adverse supply shocks (and vice versa.)  And I think they do.  If not, they should aim for 2% inflation come hell or high water.  And that’s clearly not what they do.  But this dual mandate idea also implies that if unemployment is extremely high due to deficient demand, the Fed should try to aim for above 2% inflation to try to bring it down.  Yet the Fed seems to vehemently deny any intention of aiming for above 2% inflation during a period of 9.5% unemployment.  Why?  What sort of social welfare function allows for accommodating supply shocks (or financial crises) but doesn’t allow for an aggressive move against deficient demand?

Of course all this confusion would be eliminated with . . . NGDP targeting.

Fun quotations:

[William Poole] The one other case is not a U.S. case but Japan. I think the Japanese have also suffered from not being very clear that they do not want deflation, particularly as the situation developed in the early 1990s. The markets were left quite at sea in trying to figure out where Japanese monetary policy was going to go.

CHAIRMAN GREENSPAN. I think they still are.

MR. POOLE. Yes, they probably still are.

And this probably describes September 2008:

A third potential cost could arise if your credibility were seen to be diminished when inflation differed from the stated objective. Finally, a commitment to an explicit price objective could constrain future actions of the FOMC in an unhelpful manner. For example, the Committee might feel inhibited in responding as aggressively as it would like to a financial crisis if inflation were already to the high side of the Committee’s objective. [Wilcox, et al.]

I don’t quite agree with this, but it is interesting:

[Gramlich] There’s an old experiment that I learned about in graduate school from Richard Ruggles, who used to be a professor at Yale: Offer somebody $10,000 and the choice of ordering from a catalog of all goods and services made this year or five years ago, and take a poll on which option they vote for. Try it. You all give talks to Chambers of Commerce and so forth. I’vebeen doing it for years, and people will consistently vote for the current menu. Obviously, this experiment has to be done at a much higher level of scientific rigor. But I think in the utility sense, even core PCE rates as high as 3 percent may be more or less consistent with price stability, given the great difficulty we have in dealing with technological change in price indexes.

The problem is that consumption is a social activity.  Do they mean you have the old catalogue and everyone else has the new one, or everyone has the old catalogue and their current nominal income.

And I’m guessing that someone like Bob Murphy won’t agree with the claim by Greenspan that they “lucked out” after easy money was pursued in 2004 despite the fact that the inflation target called for tightening:

Take the spring of 2004, when we were sitting there with a significant acceleration in core inflation. With a targeted range for inflation, conceivably we would have breached one of the limits of the target range. And the question would have automatically arisen, “Well, what are we going to do about this?” My answer would have been””and indeed at the time was”””nothing.” The reason was that I viewed the rise in prices as wholly the consequence of a rise in profit margins. But that rise in profit margins was sufficiently quick to result in a projection of core final goods prices that would be above any reasonable target we’ve been discussing today.

The point is this: That was a particular case where we knew that unit costs were not moving and that the rise in inflation was wholly a mechanical result of a one-shot event, which couldn’t continue unless unit costs started to accelerate. We lucked out.

I think people overstate the role of easy money in the sub-prime fiasco, but I included this quotation because I know that most people disagree with me.

On other topics, Tyler Cowen recently made this observation in response to data showing brisk growth in industrial output:

Yet the labor market is still “eh.”  Here is more, but again note it is wrong to reject the AD factor altogether, though it seems to be becoming less relevant over time.  Arguably AD and AS are interacting in unusual and presumably deleterious ways.

I have read too many blog posts attacking a caricatured version of either RBC theory or a narrowly defined notion of “structural unemployment” which requires excess demand for labor in significant parts of the economy.  As Arnold Kling points out, the labor market shock can be asymmetric in its effects.

From a different direction, here is Scott Sumner criticizing the recalculation argument.  I read Scott as establishing the conclusion that both AD and AS must be at work.

I don’t quite agree with the first part, where Tyler discusses the weak labor market.  I’ll simply link to my previous post, which explains why.  I do agree that our problems are partly real/structural/supply-side.  But I still think it is mostly demand-side, and that demand stimulus would even indirectly improve the supply-side (i.e., UI would be reduced below 99 weeks more quickly, which would further normalize the labor market.)

I was flabbergasted to see my first positive link from Paul Krugman.  Of course our views on the need for demand stimulus are similar, but we always seem to tangle on the nuances of some issue.  Indeed perhaps 1.5 positive cites, as this Krugman post is probably referring to me and Beckworth.  I recently published something in the National Review, and Beckworth published in the Wall StreetJournal.

Now I have a sudden fear I will lose all my right-wing friends.  I can just imagine what Bob Murphy will do with this.  And of course I’m way too right-wing to ever be embraced by the left.  I’ll be in limbo, along with Bartlett, Frum, Lindsey, Wilkinson, etc.

Oh well, que sera, sera.

PS.  My consolation is that if Milton Friedman were alive, he’d be in the same awkward position.

PPS:  I got a Business Week mention.