Friday, October 20, 2017

How does inflation work anyway?

Monetary policy, central banking and inflation are hard. It's well to remember that. Today's blog post adds up a few things that seem like they're obvious but are not.

Inflation is hard. 

Central bankers are puzzled at persistently low inflation.  From WSJ,
Ms. Yellen said, as the “biggest surprise in the U.S. economy this year has been inflation.” 
“My best guess is that these soft readings will not persist, and with the ongoing strengthening of labor markets, I expect inflation to move higher next year,” Ms. Yellen said, adding that “most of my colleagues on the [interest-rate-setting Federal Open Market Committee] agree.”
Of course, they've been expecting that for several years now.  And she seems fully aware that they may be wrong once again:
She cautioned, however, that U.S. central bankers recognize recent low inflation could reflect something more persistent. “The fact that a number of other advanced economies are also experiencing persistently low inflation understandably adds to the sense among many analysts that something more structural may be going on,”  
"Something more structural" is a pretty vague statement, for the head of an agency in charge of inflation, that has hundreds of economists looking at this question for years now! That's not criticism. Inflation is hard.

Why is it so hard? The standard story goes, as there is less "slack" in product or labor markets, there is pressure for prices and wages to go up. So it stands to perfect reason that with unemployment low and after years of tepid but steady growth, with quantitative measures of "slack" low, that inflation should rise, as Ms. Yellen's first quote opines.

That paragraph contains a classic economic fallacy, that of composition; the confusion of relative prices and the level of prices and wages overall. If labor markets get "tight," companies finding it hard to find workers, then yes, one expects wages to rise. But one expects wages to rise relative to prices. You only tempt workers to move to your company by offering them wages that allow them to buy more. Similarly, if there is strong demand for a company's products, its prices will rise. But those prices rise relative to other prices and to wages. Offering a company higher prices when its wages, costs, and competitor's prices are all rising does nothing to get it to produce more.

So, in fact, standard economics makes no prediction at all about the relationship between inflation -- the level of prices and wages overall; or (better) the value of money -- and the tightness or slackness of product and labor markets! The fabled Phillips curve started as a purely empirical observation, with no theory.


To get there, you need some mechanism to fool people -- for workers to see their wage rise, but not realize that other wages and prices are also rising; for companies to see their prices rise, but not realize that wages, costs, and competitors' prices are also rising. You need some mechanism to convert a rise in all prices and wages to a false perception that everyone's relative prices and wages are rising. There are lots of these mechanisms, and that's what economic theory of the Phillips curve is all about. The point today: it is not nearly as obvious as newspaper accounts point out. And if central bankers are a bit befuddled by the utter disappearance of the Phillips curve -- no discernible relationship, or actually now a relationship of the wrong sign, between inflation and unemployment, well, have a little mercy. Inflation is hard.

By the way, the oft-repeated mantra that "inflation expectations are anchored" offers no solace. In fact, it makes the puzzle worse. The standard Phillips curve says inflation = expected inflation - (constant) x unemployment. Variation in expected inflation is usually an excuse for a Phillips curve failure. Steady expected inflation means the Phillips cure should work better! (But beware that anchor. Is it anchored, or just not moving?)

Is policy tight or loose right now? 

You'd think this were an easy question. The newspapers ring with "years of extraordinary stimulus" and "unusually low rates."  And indeed, interest rates are low by historical standards, and relative to rules such as John Taylor's that summarize the successful parts of that history.

But ponder this. What does a central bank look like that is holding interest rates down? Well, it would be lending out a lot of money to banks, who would turn around and re-lend that money at higher interest rates. What does our central bank look like? Our central bank is taking in $2.2 trillion  from banks, and is paying them a higher interest rate than they can get elsewhere. Right now, the Fed is paying banks 1.25% on their reserves.  But Treasury bills are 1%. Even commercial paper is 1.13-1.2%. It looks every bit like a bank that is pushing rates up. And has been doing so for a long time.

How is this remotely possible? Well, historical interest rates reflected different circumstances. Interest rates around the world are lower than in the US. EU policy rates are about  -0.5% and stuck there. Real interest rates are negative all over the world. If real interest rates are very low, and inflation is very low, nominal interest rates will be very low, no matter what they were historically.

For example, when interest rates hit 10% in the 1970s, higher than ever before seen, did that mean monetary policy was incredibly tight? No, as it turns out.

Supply vs. demand.

The central bank's main job, at least as monetary policy is currently construed, is to distinguish "supply" from "demand" movements in the real economy. If GDP falls because of "lack of demand," it is the Fed's job to stimulate by lowering interest rates, and then by other means such as QE and speeches. If GDP falls because of "lack of supply" however, the Fed should not respond, as that will just create stagflation.

It's really hard to tell supply from demand in real time. Here again, most commentary just assumes it's one or the other, and usually all demand -- a failing that is common throughout economic policy. Textbook models assume that central banks observe and respond to shocks, and know where those shocks come from. Not so in life.

Policy for growth? 

This issue came up sharply in the last two days. The Wall Street Journal's "Fed for a growth economy" and George Shultz and John Cogan's "The Fed Chief America Needs" pose the question, how should monetary policy adapt if there is an era of supply-side growth, triggered by cuts in marginal tax rates and deregulation?

Pop quiz: How should monetary policy be different in a time of supply-side growth?

I bet you said "keep rates lower for longer." Maybe you're right. The growth is not a sign of future inflation, via the usual excess demand - more growth - more inflation channel. But didn't we (and the Journal) just say the Phillips curve is broken?

More importantly, an economy that grows faster should have higher real, and therefore nominal, interest rates. The first equations of macroeconomics are

real interest rate = (elasticity) x consumption growth rate
real interest rate = marginal product of capital

If we're growing faster, tomorrow is better than today, and interest rates need to be higher to convince people to save rather than spend today. If we're growing faster, it's because investment is more productive, and we need higher interest rates to attract capital to that investment.

So, higher growth should be accompanied by higher interest rates. Like everything else in economics, there is supply and demand. Higher rates can choke off demand. But higher rates can reflect good supply. The question is just how much higher! I did not say this would be easy.

You can tell in the WSJ commentary a feeling that Ms. Yellen and the standard way of thinking about monetary policy would get this wrong, and raise rates too much -- responding to growth, thinking that inflation is still just around the corner, on the belief that growth is always "demand" rather than supply. I'm not agreeing with this, just stating the implicit view.

How would the Taylor rule do here? Pretty well, actually. Taylor's rule specifies that the Fed should respond to the output gap -- the difference between the level of output and the full employment, or supply side limit -- not to the output growth rate. So if "potential GDP" rises from supply improvements, the gap increases, and Taylor's rule says to keep rates low. When the economy achieves the gap, return to normal. The rule might have to adjust to the new higher trend interest rate -- a higher r* in Fed parlance -- but it would not mistake growth.

That is, if the Fed correctly measured "potential" GDP and recognized that supply side improvements have increased potential. Standard calculations of potential GDP do not factor in marginal tax rates or deregulation, and look to me largely like two-sided moving averages. Again, distinguishing supply from demand, in real time, is hard. 

A pure inflation or price level target might do even better, by getting the Fed out of the business of trying to diagnose supply vs. demand. But, advocates of a Taylor rule with a strong output component, or of the current Fed might say, by reacting to output (and relying on the Phillips curve) you can stabilize inflation better anyway, but nipping it in the bud. An the Fed has an explicit employment mandate that can't be ignored.  I didn't say this was going to be easy.

How's this thing work anyway? 



The wizard of OZ, charmingly, announced he didn't know how the thing works. Does the Fed? Just how are interest rates related to inflation? This is our last on the list of things that seem obvious but aren't obvious at all.


If you just plot inflation and interest rates, they seem to move together positively. Teasing out the notion that higher rates lower inflation from that graph takes a lot of work. My best guess, merging theory and empirical work, is that higher rates -- moved on their own, not in response to economic events -- temporarily lower inflation, but then if you stick with higher rates, inflation eventually rises. And vice versa, which accounts for very low inflation after interest rates have been stuck low for a long time. Maybe yes, maybe no, but even this much is not certain.




14 comments:

  1. Problem one is that inflation is a generic term and it use in a model mens defining an index which is an incomplete description. If double entry accounting is correct, then the price level change is mostly zero, over the 60 year period, or deflation for another two decades. hy would the double entry accounting system be fooled? What is the evidence? Take out housing and medical from consumer goods and you mostly get deflation in consumer prices. But that is an unfair index, as is any other index. It leaves out producer prices and many government goods, and usually mis-measures trade balance.

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  2. Dear The Grumpy Economist,

    Inflation is hard? We need to take a fresh look from a different perspective. Inflation is easier if you know time-series algebra on NIPA data to decompose PCE price index into ULC(Unit Labor Costs) and ULP(Unit Labor Production) as follows.

    1. PCE = ULC(Unit Labor Costs)*ULP(Unit Labor Production)
    2. %PCE = %ULC + %ULP + %ULC*%ULP

    %PCE = YoY % Change in PCE level = PCE-based Inflation
    %ULC = YoY % Change in ULC= Wage-Push Inflation
    %ULP = YoY % Change in ULP= Production-Pull Inflation

    Notes: in chart,
    (1) %ULC is in red thick line on LHS and ULC is in red thin line on RHS
    (2) %ULP is in blue thick line on LHS and ULP is in blue thin line on RHS

    For Q2 2017,
    ULC=0.60295. It means $0.60295 wage cost for each $1 real output
    ULP=1.87158. It means $1.87158 production(GDP) for each $1 wage
    %ULC=0.62364%
    %ULP=0.88972%
    %PCE(Inflation Rate)= 0.62364% + 0.88972% + 0.62364%*0.88972% = ~1.5%

    In order to achieve 2% inflation target rate on Q3 2017, I assume this more easier path: 0.5% from wage-push inflation and 1.5% from production-pull inflation. Thus,

    ULC(Q3 2017) = 0.60514 = 1.005*ULC(Q3 2016)(red dash line on RHS)
    ULP(Q3 2017) = 1.88310 = 1.015*ULP(Q3 2016)(blue dash line on RHS)

    Currently US economy, as seen in the chart, our ULC is very high and flat around 0.60. There is limit in ULC (ULC < 1). Also, it is not easy in increasing wage-push inflation(%ULC) due worker ages in US labor market. The ratio of workers (age > 35) over workers (age < 34) = 1.87(shown as yellow line on RHS in chart).

    ULP is low, but no limit in ULP(ULP > 1) and more easier in increasing production-pull inflation


    Chart in image format

    https://fred.stlouisfed.org/graph/?g=ftGk

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  3. Perhaps Yellen and all those journalists could do with reading Friedman's "The role of Monetary policy". Inflation isn't hard, escaping the tyranny of interest rate based policy is.



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  4. Great post John, it is reassuring to see some economists questioning the old assumptions, I do agree that this crisis has shattered many of our previous deeply held "knowledge" of monetary policy.

    I have tried to argue that a tighter labor market as a whole should affect the composition between profits and wages, not inflation, but a lot of people have been hearing the wrong story for so long that they can no longer realize how this makes much more sense from a general equilibrium perspective.

    Regarding the other questions, I share your intuition on the effect of interest rates. Lower interest rates decreasing inflation over the long run seems actually to be quite intuitive when one understands the FTPL, if the liabilities of the State are growing at a lower rhythm (for fixed surplus), inflation will be lower. Why it should increase first is harder to understand, but my sense is that it probably requires a model with heterogeneous agents.

    Given this intuition, I do think that the other questions you raise are less important. Interest rates being too low or too high is probably a problem when we CHANGE the interest rate and are under the liquidity effect, once the fisher effect sets in and inflation follows the nominal rate, the real rate will be the natural one for whichever nominal rate that one chooses.

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  5. Just sell “price status insurance” and inflation will magically not be problem.

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  6. John,

    "If you just plot inflation and interest rates, they seem to move together positively. Teasing out the notion that higher rates lower inflation from that graph takes a lot of work."

    Which is funny, because the Taylor rule advocates a Federal Reserve policy of higher nominal interest rates in response to higher inflation. So higher inflation begets higher interest rates which begets even higher inflation?

    "My best guess, merging theory and empirical work, is that higher rates -- moved on their own, not in response to economic events -- temporarily lower inflation, but then if you stick with higher rates, inflation eventually rises."

    What is Mr. (future Fed chairman) Taylor's best guess / theory?

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  7. I've been scratching my head for some time now over what John points out - that bank reserves have been quite high and the Fed has been encouraging it. So can someone explain to me why the Fed has been doing this since they have been perpetually unable to increase inflation? It certainly doesn't seem consistent.

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  8. Can't tell if my last comment made it through or not so I'll repeat it.

    I've been scratching my head for some time now over what John points out - that bank reserves have been high and the Fed has been encouraging it. So can someone explain to me why have they been doing this if they've had so much difficulty increasing inflation? Doesn't seem consistent.

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    Replies
    1. Because the Fed, like the wizard, isn't really sure how the thing works. Huge amounts of interest-paying reserves, paying interest greater than what banks can get elsewhere. Is this a huge amount of "money" stoking inflation? Is this a huge amount of "bonds" soaking up money? Is this "paying the banks not to lend?" Is it a "quiet recapitalization" i.e. a subsidy to the banks profits? Is it just a psychological shell game, to demonstrate to the markets how committed the Fed is to stimulus (that's the best guess of many academic articles looking at QE? Inflation is hard, and I don't think the Fed is quite of one mind on how things work.

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    2. Well, inflation can't be that hard because Venezuela, Zimbabwe, and the Weimar Republic had no problems generating it.

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    3. Generating a lot of inflation is easy. Generating just a little is hard.

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    4. I'm no economist, but it always seemed obvious to me that the way inflation was explained in economics textbooks didn't match reality. What does match the data (over the long-term): when the Federal Reserve holds interest rates high, inflation will be high. When the Federal Reserve holds rates low, inflation will be low.

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  9. I am sympathetic to most of this post, but the following strikes me as incorrect

    "By the way, the oft-repeated mantra that "inflation expectations are anchored" offers no solace. In fact, it makes the puzzle worse. The standard Phillips curve says inflation = expected inflation - (constant) x unemployment. Variation in expected inflation is usually an excuse for a Phillips curve failure. Steady expected inflation means the Phillips cure should work better! (But beware that anchor. Is it anchored, or just not moving?) "

    Suppose that inflation expectations were well anchored at 1.5%. Then inflation comes in quarter after quarter at 1.8% Using an expectations augmented Phillips curve one would expect for unemployment to steadily decline despite the low an stable inflation rate.

    Or put another way, well anchored expectations mean that the same policy could continue to fool people year-after-year, resulting in falls unemployment year-after-year. There may be lots of reasons to think this is unlikely but I think it does help to rescue the Phillips Curve case.

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  10. I wanted to point out that this post has stuck with me for a few weeks now. So I'd emphasise that I fully appreciate the content and it is highly valuable and interesting (even if perhaps there are relatively few comments).

    There's lots of technical arguments here. My follow up thought is that if the best resourced reserve bank in the world finds the application of its mandate difficult to pull off in reality, then doesn't that suggest that Reserve Banking is subject to the same central planning failures of any other market? I don't know the alternative here, but clearly there are shortcomings in the process if the Reserve can't actually tell what causes inflation (let alone whatever extraordinary intellectual powers that an economic theory might assume that homo economicus might possess).

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