Strange respect for central banks
In the past, I’ve argued that our overly respectful view of central bankers has led us to misdiagnose recessions. Indeed it has led us to distort macroeconomic theory.
In basic macro theory the path of NGDP is determined by monetary policy. Recessions occur when NGDP growth falls suddenly and unexpectedly. Thus it seems logical to assume that whenever there’s a demand side recession it is the Fed’s fault.
The profession greatly respects people like Bernanke, Yellen and Draghi, as they should. These are talented central bankers. But we should not let that well deserved respect influence the way we think the macroeconomy works. Unfortunately, that’s exactly what we do.
The Economist recently did a long article on the mystery of low inflation. Overall it’s a good article, well worth reading. But there are a few problem areas. Here’s one:
Later in the decade, amid low unemployment rates, monetary policymakers became more attuned to the risk of overheating. It would be odd, however, to explain low inflation by appealing solely to deliberate choices on the part of central banks, when they themselves profess to be confused by inflation’s quiescence.
A bus is driving from Los Angeles to Vegas. At some point the bus goes off course, and ends up in the Mojave Desert, 20 miles from I-15. The bus driver’s labor union points out that this is a skilled driver. “It would be odd to attribute the location of the bus to choices made by the bus driver. More likely, an electromagnetic pulse from outer space affected the bus’s navigation system.” How would that excuse work?
Think about it. The Fed raised rates 9 times. Each rate increase was done with the intention of preventing inflation from overshooting the Fed’s 2% target. They relied on a flawed Phillips Curve model that predicted that low unemployment would cause high inflation.
Yes, “they themselves profess to be confused”. I’m sure the errant bus driver was also confused. But is this any reason to absolve them from making bad decisions? Why wouldn’t you blame low inflation on the choices of the central bank?
Not all central banks have trouble hitting their 2% inflation target. In the UK, inflation has averaged 2.06% over the past decade. If you insist on excluding the last three years (when inflation was boosted by the Brexit depreciation of the pound), it’s 1.97%. If you take the past 20 years, it’s 2.02%.
The Economist piece also has a long discussion of how supply side factors might have played a role in low rates of measured inflation. Unfortunately, the evidence suggests that this is wrong. Technological innovations such as the “Amazon effect” can only reduce inflation to the extent that they boost productivity growth. But productivity growth has been slower since 2004. Thus the data do not provide even a necessary condition for considering the hypothesis that productivity gains (or any other supply side factors, such as trade with China) is holding down inflation. James Pethokoukis has a cute tweet:
PS. Even if technological progress were rapid, it would not hold down measured inflation, due to monetary offset. At best, it might reduce actual inflation if the rate of progress were underestimated.
PPS. The article ends up endorsing NGDP targeting, and there are other good parts as well.
HT: David Beckworth
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23. October 2019 at 11:29
Is that really a valid of example of automation resulting in less jobs? Think of how many jobs going forward are created by the existence of Netflix who aren’t direct employees like actors, writers, technology, directors, advertisement, etc. The 5500 vs 85,000 just seems like a simplistic comparison if you don’t factor in the entire spectrum of business and innovation.
23. October 2019 at 11:47
Wasn’t the fear of central bankers back in 2010-2011 was there was a pretty fast acceleration in inflation, but unemployment barely budged. My guess is that supply side factors were a big issue on inflation back in 2011, but the fiscal reforms that Congress forced Obama to pass in 2013(reducing unemployment insurance, reducing deficit spending), allowed for the Federal Reserve to accelerate expansionary monetary policy without fear of really bad inflation, as the supply side picture dramatically improved.
I’m also sure that fracking and other factors helped out as well.
https://fred.stlouisfed.org/series/T10YIE
https://fred.stlouisfed.org/series/UNRATE
23. October 2019 at 11:49
Given the inflation pressure that central banks were hitting in the early post-recession years, I think they did a fairly good job from 2011-2014. Afterwards though, their inflation target is a huge swing and a miss.
23. October 2019 at 11:51
Of course, this all could be wrong, but it implies that the Fed did what it could back in the early days of the recovery, and once inflationary pressures subsided, they quickly moved to radically reduce unemployment
23. October 2019 at 12:44
Eric, Agreed, automation doesn’t reduce the number of jobs.
John, You said:
“Given the inflation pressure that central banks were hitting in the early post-recession years, I think they did a fairly good job from 2011-2014. Afterwards though, their inflation target is a huge swing and a miss.”
They did a horrible job, once you recall the Fed has a dual mandate. They are supposed to look past temporary spikes in oil prices.
In recent years they’ve done a much better job.
23. October 2019 at 13:13
Hello Scott,
I’ve enjoyed your posting for years. I’m afraid after only two macro econ classes, however, that I often can’t follow the reasoning behind NGDP targeting as lucidly as I’d like.
Do you have any books/textbooks you recommend that argue for your view of monetary policy? Are there any “explainers” from your archive that walk through the logic step-by-step?
Thanks,
-Scott
23. October 2019 at 13:57
Scott: you were right it was an oil spike. I had forgotten. Then your analysis is right.
23. October 2019 at 20:14
OT but in the ballpark.
Why and when did exactly 2% on the PCE become sacralized?
I realize we live a base-10 world, but what makes 2% better, than, say, 2.30%? It would seem to me if someone tried to model the best target inflation rate, they would not come up with exactly 2%, but rather some number between 2% and 3%.
I suspect 3% would work better, btw. The US had some great decades with the CPI near 3% and real GDP growth also at 3%.
Other notes:
The Reserve Bank of India recently discussed a 40 basis point rate cut. Not 0.25% only. The quarter-point system actually extends back to Spanish doubloons, believe it not. That is why stocks used to be traded in 1/8th, 1/16th etc.
So here we are in 2019, and the Fed can only cut or raise by quarter points.
Also the Bank of Japan meets 12 times a year. not eight (the Fed model). Why does the Fed meet for policy eight times a year? You know, those trains take forever to get from SF to DC.
The Fed has sacralized many a totem.
24. October 2019 at 07:42
Scott, Unfortunately the book I wrote is not out yet—publishers take forever.
In the right margin of this blog (scroll down), there’s a section of “Quick intro to my views” which has some sets of posts that are sort of short courses on my ideas.