Why is inflation so stable?10th July 2019
Three different people directed me to a Robert Barro column that asks how the Fed achieved its recent success in inflation targeting:
Judging by the US inflation rate over past decades, the Fed’s monetary policy has worked brilliantly. Annual inflation has averaged only 1.5% per year since 2010, slightly below the Fed’s oft-expressed target of 2%, and has been strikingly stable. And yet, the question is how this was achieved. Did inflation remain subdued because everyone believed that anything significantly above the 1.5-2% range would trigger a sharp hike in the federal funds rate?
Barro discusses research by Emi Nakamura and Jón Steinsson in the Quarterly Journal of Economics, which finds evidence that “a contractionary monetary shock – an unanticipated rise in the federal funds rate” – reduces inflation, but that significant effects occur only after 3-5 years. And there’s an even greater mystery in this study:
Although unexpected increases in the federal funds rate are conventionally labeled as contractionary, Nakamura and Steinsson find that “forecasts about output growth” actually rise for the year following an unexpected rate hike. That is, a rate increase predicts higher growth, and a decrease predicts lower growth. This pattern likely occurs because the Fed typically raises interest rates when it gets information that the economy is stronger than expected, and it cuts rates when it suspects that the economy is weaker than it previously thought. . . .
[T]he puzzle is how the Fed can keep inflation steady at 1.5‑2% per year by relying on a policy tool that seems to have only weak and delayed effects. Presumably, if inflation were to rise substantially above the 1.5-2% range, the Fed would initiate the type of dramatic increases in short-term nominal interest rates that Volcker carried out in the early 1980s, and these changes would have major and rapid negative effects on inflation. Similarly, if inflation were to fall well below target, perhaps becoming negative, the Fed would sharply cut rates – or, after hitting the zero-lower bound, use alternative expansionary policies – and this would have major and rapid positive effects on inflation.
According to this view, the credible threat of extreme responses from the Fed has meant that it does not actually have to repeat the Volcker-era policy. Rate changes since that time have had modest associations with inflation, but the hypothetical possibility of much sharper changes has remained powerful.
Frankly, I am unhappy with this explanation. It is like saying that the inflation rate is subdued because it just is.
Some economists believe that fiscal policy determines the inflation rate. For that group, the answer to the question in the post title is simple: Since 1990, Congress has been taken over by a set of economic geniuses, who have deftly steered fiscal policy in a way that keeps inflation close to 2%, something not seen in earlier periods of history. (Inflation averaged near zero under the gold standard, and was very erratic on a year-to-year basis. It averaged far above 2% during 1966-90.)
Barro and I prefer a monetary explanation for inflation. His textbook entitled “Macroeconomics” provides what I regard as the clearest and most elegant model of important nominal variables such as the price level and interest rates. (At least the best model at the first year econ grad student level.) He does a beautiful job discussing money neutrality and super-neutrality. He argues that changes in the price level are best modeled in terms of changes in the supply and demand for base money. That’s also my preference.
His textbook model shows how the Fed could control prices by adjusting the supply of base money and, after 2008, also the demand for base money (via changes in IOR.) Thus in a technical sense there is no mystery at all. The Fed adjusts the base and IOR as needed to stabilize inflation at close to 2%. The fact that the Fed uses interest rate targeting is a mere technical detail—prior to 2008 they adjusted the fed funds rate by moving the supply of base money. In Barro’s model, it is the supply and demand for base money that matters.
So where is the “mystery” that Barro refers to? I see two possibilities:
1. The Fed’s monetary instruments have behaved in an unusual fashion in recent years. The relationship between the base and the price level is much weaker than before 2008.
2. The long lags identified by Nakamura and Steinsson raise the question of how the Fed knows where to set their policy instruments today, in order to hit inflation goals 3 to 5 years into the future.
Obviously these two issues are related. If base velocity is unstable, or if the natural rate of interest is unstable (or both), it’s not at all clear how the Fed is able to figure out where to set their instruments today in order to achieve their long run policy goals.
My best guess is that the Fed relies on the following three assumptions:
1. Stabilizing the future expected price level goes a long way toward stabilizing near-term inflation. As an analogy, imagine the government wanted to stabilize the price of gold, but its only tool (digging new gold mines) took 3 to 5 years to implement. Could they stabilize current gold prices, with such long lags?
The answer is probably yes, as even stabilizing expected gold prices 3 to 5 years in the future will tend to stabilize current gold prices. No one would sell gold for $800 or buy gold at $1200 today if they thought the government would move gold prices to $1000 in 4 years. The same applies to the overall price level, which depends heavily on the future expected price level. (This is not just my view, but also the implication of more sophisticated macro models.)
That still doesn’t answer Barro’s question, but it gets us part way there. There are two more components:
2. The Fed reacts to previous misses in its target, with easing or tightening of monetary policy.
3. The Fed also pays some attention to market forecasts, which provide additional policy guidance, beyond recent macro data.
Think of a ship captain steering a tanker across the ocean, toward NYC. Even if the captain is relatively clumsy, and doesn’t have a very good idea as to how much to adjust the steering wheel when he gets off course, he should be able to eventually reach NYC under these conditions:
1. He knows where NYC is.
2. He knows which way to turn the wheel when he gets off course.
3. He has enough power to overcome wind and waves.
Central banks generally have enough power to steer nominal aggregates, even at the zero bound. (Although there may be a few cases where they do not, due to strict constraints on what they can buy at the zero bound.) They know which way to adjust monetary policy when they get off course. And they have a 2% inflation goal and know when they have gotten off course.
The tendency of the current inflation rate to be heavily influenced by the future expected price level makes inflation relatively inertial under an inflation-targeting regime (but not under a 1970s-type regime). And because of this inertia, even relatively “clumsy” central bankers can target inflation fairly effectively, because they can eventually get the price level back on course. Greenspan was viewed as a “maestro” for his policy successes, but other central banks did roughly as well after 1990, a sign that it was the new inflation targeting regime, not the skill of the leader, that was decisive.
The ship analogy actually understates the ability of central banks to control inflation. In the world of sailing, trend reversion does not reduce the severity of wind and waves. But in the world of monetary economics, a credible policy of stabilizing long run inflation tends to reduce “shocks” such as fluctuations in velocity and or the natural rate of interest. The better they do their job, the easier the job gets.
The head of the Australian central bank has an easier job than the head of the Japanese central bank, a country where previous tight money mistakes led to deflation that reduced velocity and the equilibrium interest rate, necessitating far more drastic actions by the BOJ today.
PS. I did not discuss the real growth puzzle in the Nakamura and Steinsson study. I suspect that Barro is correct that it reflects policy responses to expected future changes in growth. Indeed we are seeing something like that today, with likely rate cuts in anticipation of slower growth ahead. This is part of the broader “identification problem” in monetary economics, aka “never reason from a price change”.
HT: Nicolas Goetzmann, Ramesh Ponnuru, Stephen Kirchner
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