Project Syndicate: Why Low Inflation Is No Surprise by J. Bradford DeLong: BERKELEY – The fact that inflation has remained stubbornly low across the global North has come as a surprise to many economic observers. In September, the always sharp and thoughtful Nouriel Roubini of New York University attributed this trend to positive shocks to aggregate supply…. In my view, interpreting today’s low inflation as a symptom of temporary supply-side shocks will most likely prove to be a mistake. This diagnosis seems to misread the historical evidence from the period between the early 1970s and the late 1990s… Read MOAR at Project Syndicate
Live at Project Syndicate: The Truth Behind Today’s US Inflation Numbers https://www.project-syndicate.org/commentary/fed-low-inflation-more-stimulus-by-j–bradford-delong-2017-06: BERKELEY – In December 2015, the US Federal Reserve embarked on a monetary-tightening cycle, by raising the target range for the short-term nominal federal funds rate by 25 basis points (one-quarter of a percentage point). At the time, the Federal Open Market Committee (FOMC)–the Fed body that sets monetary policy–issued a median forecast predicting three things… Read MOAR at Project Syndicate
Of course, post-2007 fits none of these patterns because of the zero lower bound…
Must-Read: the sharp Ryan Avent, I think, nails it:
Expect the Worst: “It wouldn’t make sense for the Fed to target real GDP growth, but then, the Fed is not really in that business…:
…The Fed is also unable to control the long-run real interest rate, which is a function of global saving and investment. What’s more, it does seem clear that the global real interest rate has settled down to a level of approximately zero. But does it follow that the Fed should then either 1) set a high nominal interest rate in order to achieve higher inflation, or 2) keep its interest rate low and accept low inflation? I don’t believe so…. It is not the case that the Fed is choosing low rates and inflation expectations are therefore converging toward a low level…. The Fed has been targeting very low inflation, and falling inflation expectations imply much lower interest rates in future. This dynamic is there back in 2013. In its projections the Fed indicates that rates will rise steadily, even as it projects that inflation will be extraordinarily low, just over 1% in 2013, converging, finally, toward 2% by the end of 2015. Essentially every set of Fed projections since then has shown the same thing. It allowed its QE programmes to end despite too-low inflation, and it raise its interest rate in December despite too-low inflation. The Fed has signalled very strongly that markets should expect inflation to remain at very low levels, indeed, below target. It would be shocking if inflation expectations hadn’t trended inevitably downward….
Is there a route out?… Where in the past the Fed has promised to raise rates even as inflation stays low, it could instead promise to keep them low no matter what, even if, and indeed until, inflation rises above the target. If the Fed wants higher nominal rates in a world of low real rates, it must cultivate higher inflation…. The Fed can choose whether nominal rates get stuck near zero or rise to a higher, safer level. Right now, unfortunately, it is steering the American economy firmly into a low-rate rut.
Must-Read: As I was just saying yesterday: Take the rate of profit–typically 6% to 7% per year–on the operating companies that make up the stock market. Subtract the risk premium–typically 4%. Add on the expected inflation rate–2.5% on the CPI basis. Get 4.5% to 5.5%. That is what the nominal interest rate on Treasury bills is likely to be in normal times toward the end of a healthy expansion. That provides a healthy amount of room for the Federal Reserve to cut interest rates to encourage spending and support the economy when a recession comes. But note that 5% of sea-room to cut interest rates when necessary was not nearly enough back in 2007-2010.
Now suppose that we are entering an age of secular stagnation. It will have a higher risk premium–say 5-6%. Slower growth will have an impact on the rate of profit for operating companies–knock, say, 1-2% off their typical value. Go through the math, and we get a likely nominal interest rate on Treasury in normal times toward the end of a healthy expansion of roughly 1-3%, not 5%.
The dot-plots tell us that the FOMC now thinks that it is headed for a 3% Treasury Bill rate–at the upper end of this range, but still very far from a 5% rate. And if we do live in a semi-permanent age of secular stagnation, this will not be a temporary inconvenience but, rather, a permanent structural fact.
That means that if the FOMC keeps its current inflation target then it will have only 3% of sea-room when the next big recession comes, whether next year, next decade, or a quarter century from now.
That means that if the FOMC keeps attempting to raise interest rates back to a 5% normal–or even, unless it is lucky, to a 3% normal–it will find itself continually undershooting its inflation target, and continually promising that rates will go up more real soon now as soon as the current idiosyncratic fit of sub-2% inflation passes.
I do not know anybody seriously thinking about all this who thinks that 3% of sea-room is sufficient in a world in which shocks as big as 2007-2010 are a thing. And I do not know anybody seriously thinking about all this who thinks that pressing for a premature “normalization” of interest rates is a good idea: It will deanchor inflationary expectations on the downside, and with rational market inflation expectations 1-2% below the “target” that means an equilibrium late-expansion Treasury Bill rate of not 1 to 3% but rather -1 to 2%.
Therefore either (a) the Federal Reserve really should raise its inflation target, or (b) the Federal Reserve should right now be screaming to high heaven about how it is the necessary and proper task of the rest of the government to do something, something big, something now to resolve our secular stagnation problem. And under no circumstances should the Fed be (c) pushing for probably premature “normalization” of interest rates.
Of course, the Fed could and should be doing both (a) and (b). But it seems to be doing neither–it seems to be doing (c).
Perhaps Janet’s thoughts on secular stagnation are part of process of trying to assemble an FOMC coalition to… do something… or at least beg others to do something…
But this intellect, at least, is pretty pessimistc.
A Question For the Fed: “There is a near-consensus at the FOMC that rates must eventually move up…:
….But… exactly?… Which component of aggregate demand do we believe will continue to strengthen in a way that will require monetary tightening to avoid an overheating economy? Here’s a look at two obvious candidates… as shares of potential GDP… deviations from the 1990-2007…. Nonresidential investment has basically recovered from the recession-induced slump. Residential investment is still a bit low by historical standards, but not as much as you might think…. So I don’t see an obvious reason to believe that current rates are too low. Yes, they’re near zero–but that in itself doesn’t mean too low. Like others, notably Larry Summers, I think the Fed is trying to return to a normality that is no longer normal.
Must-Read: Newest Inflation Expectations Likely to Trouble the Fed: “The Federal Reserve probably won’t like the latest data out of the University of Michigan on Friday…:
…inflation expectations over the next five to ten years dropping to 2.3% in June, a record low…. That’s on top of market-based inflation expectations that have also fallen over the past month…. When Federal Reserve Chairwoman Janet Yellen spoke on Monday, she drew attention to inflation expectations as a key input in actual inflation. She said:
It is unclear whether these indicators point to a true decline in those inflation expectations that are relevant for price setting; for example, the financial market measures may reflect changing attitudes toward inflation risk more than actual inflation expectations. But the indicators have moved enough to get my close attention. If inflation expectations really are moving lower, that could call into question whether inflation will move back to 2 percent as quickly as I expect….
The market is taking note as well. Benchmark 10-year Treasury note yields dropped to their lowest of the day after the data and recently traded at 1.63%, a new low for the year on a closing basis…
Must-Read: If people on the FOMC had known late last November that the first half of 2016 would be as bad as it is shaping up to be–a GDP growth rate that looks to be 1.7%/year rather than 2.4%/year, and a PCE-chain inflation rate of not 1.6%/year but 0.8%/year–how many of them would have pulled the trigger and gone for an interest rate increase last December?
I confess I do not know why Lael Brainard is saying “there is uncertainty that future data will resolve in the near-term and so we should wait” rather than “if we knew then what we know now we wouldn’t have raised rates in December, and so we should cut”:
Fed’s Lael Brainard Calls for ‘Waiting’ as Labor Market Has Slowed: “Brainard, who’s the first Fed official to speak since the Labor Department…:
…reported just 38,000 jobs were added in May, said the central bank should wait for more data on how the economy is performing in the second quarter, as well as a key vote by Britain on whether to leave the European Union. ‘Recognizing the data we have on hand for the second quarter is quite mixed and still limited, and there is important near-term uncertainty, there would appear to be an advantage to waiting until developments provide greater confidence,’ Brainard said at the Council on Foreign Relations. She said she wanted to have a greater confidence in domestic activity, and specifically mentioned the uncertainty around the Brexit vote, as reasons to pause at the next Federal Open Market Committee meeting, which is due to end June 15…
Must-Read: By now we can no longer understand the Federal Reserve Chair as needing to maintain harmony on a committee that has on it many regional reserve bank presidents who have failed to process the lessons of 2005-2015. By now all the regional bank presidents are people whom the Federal Reserve Board has had an opportunity to veto:
There Goes the Fed’s Credibility: “The Federal Reserve promised to keep its preferred measure of inflation…:
…close to 2 percent over the longer run…. Some would say that central banks are out of ammunition…. Actually, though, the Fed has been deliberately tightening monetary policy over the past three years. Just last week, Chair Janet Yellen made a point of saying that the Fed intends to keep raising interest rates in the coming months….
Would it have started pulling back on stimulus in May 2013 if its short-term interest-rate target had been at 5 percent instead of near zero, and if it hadn’t been holding trillions of dollars in bonds? I strongly suspect that the Fed would instead have added stimulus by lowering interest rates…. The Fed’s current course is driven not by the state of the economy, but by a desire to get interest rates and its balance sheet back to what is considered ‘normal.’ Savers, bankers and many politicians agree with this objective…. The Fed, however, promised to focus on actual economic outcomes….
Investors’ doubts [about the Fed] aren’t surprising, given the Fed’s focus on ‘normalizing’ interest rates rather than on hitting its inflation target. Such concerns will create an extra drag on the economy if and when bad times do come. In other words, the Fed’s willingness to renege on its promises seems likely to make the next recession worse than it otherwise would be.
Must-Read: Suppose you put someone in cryogenic sleep a decade ago, woke them up today, showed them this graph:
and said: “The U.S. Federal Reserve still has the same 2%/year inflation target it had in the early 2000s. Do you think it should raise or lower interest rates in June?”
I cannot think of a single reason why such a person would say “raise interest rates” (unless, of course, their compensation was an increasing function of the interest rate).
What’s the deal with U.S. wage growth?: “The U.S. unemployment rate has been at or under 5 percent for more than six months…:
…But… neither inflation nor wage growth has picked up considerably, despite expectations that they would…. First… the unemployment rate may be slightly overstating the health of the country’s labor market. Measured by the employed share of workers ages 25 to 54, the labor market has a long way to go before it hits a level usually associated with strong wage growth…. Adam Ozimek… points out that… low inflation has an impact on wage growth, because employers will be less willing to pass along wage hikes to prices, and employees will need less of a wage increase…. A third argument is that… low measured wage growth is due in part to low-wage workers moving into full-time employment…. Already-full-time employees are seeing rising wages, that growth is masked by the entrance of lower-earning workers…. It seems likely… that… five percent just isn’t what it used to be…
This from Paul Volcker strikes me as substantially wrong:
[My] first economics course… at Harvard… Arthur Smithies…. Session after session he would drill into our head that a little inflation was a good thing. And I could never figure out why. But I know he kept saying it, so already at the time I for some reason had an allergy to what he was saying. But it’s interesting, his lectures, it’s the same thing that central banks are saying today….
I would never interpret it as you have to have [inflation] exactly zero. Prices tend to go up or down a little bit depending upon whether the economy’s booming or not booming. And I can’t understand making a fetish of a particular number, frankly. What you do want to create is a situation where people don’t worry about prices going up and they don’t make judgments based upon fears of inflation instead of straightforward analysis of what the real economy is doing.
And I must confess, I think it’s something of a moral issue…. You shouldn’t be kind of fooling people all the time by having inflation they didn’t expect. Now, they answer, well, if they expect it, it’s okay. But if they expect it, it’s not doing you any good anyway. Those arguments you set forward don’t hold water if you’re expecting it…
There are three major considerations:
- In any economy with debt contracts that fix principal in nominal terms, it is easier to fall into a destructive Fisherian debt-deflation chain of bankruptcies when you have a zero rate of inflation than when you have positive inflation and so some normal-time upward drift in the price level.
- Sometimes the Wicksellian “neutral” or “natural” short-term safe real interest rate will be less than zero. That’s the rate consistent with full employment and no price-level surprises. That’s the rate at which the economy wants to be, and the rate that a central bank properly performing its stabilization policy mission will aim for. But whenever the Wicksellian “neutral” rate is, say, -x%, no central bank can get the economy there unless the inflation rate is +x%.
- People really, really hate having their nominal wages cut. Firms would thus rather reduce costs by firing people than reduce costs by cutting nominal wages: in the first case, at least the people who hate you are no longer around to cause trouble and disrupt operations. Getting your nominal wages cut is a psychological diss with substantial sociological consequences. In an environment of moderate inflation firms thus have an extra degree of effective freedom at their disposal in reacting to changing circumstances: they can raise their prices by the amount of ongoing inflation, but not give the the corresponding inflation-compensating nominal wage increases. That extra degree of freedom is worth a considerable amount to employers. And it is worth a considerable amount to workers as well–for workers hate getting fired, especially in a slack economy, much, much more than they hate having their real wages eroded by inflation.
Paul Volcker, although he would not put it this way, seems to be working with a Lucas aggregate supply curve: that the unemployment rate is equal to the natural rate of unemployment minus or plus a slope parameter times how much people have been positively or negatively surprised by inflation, and that workers’ utility is highest when unemployment is at its natural rate, and lower when unemployment is either more or less than the natural rate.
Volcker, however, would not call it a Lucas aggregate supply curve. He would call it a Smithies aggregate supply curve, or a Viner (1936) aggregate supply curve:
In a world organized in accordance with Keynes’ specifications, there would be a constant race between the printing press and the business agents of the trade unions, with the problem of unemployment largely solved if the printing press could maintain a constant lead…
It has never been clear to me why this Viner aggregate supply function has such a hold on the economics profession as a benchmark model from which you start–and, in this case, stop–thinking.
I do not think it is clear to Cardiff Garcia either. In his conversation with Volcker, he raised these points:
Cardiff Garcia: If you have zero percent inflation, then you’re closer to having a [destructive] deflationary spiral…. If you have a little bit of positive inflation, then interest rates will be correspondingly a bit higher, so if there’s a downturn, you have room to lower them. And… if you have a little bit of inflation, then it’s easier for companies to give real wage cuts to their employees without laying them off, if they just freeze their wages and then they go down because of inflation…
But Volcker does not pick up on any of these–sea-room to avoid deflationary spirals, more freedom to move the Wicksellian “neutral” rate to where it wants to be, more labor-market flexibility. He simply takes immediate refuge in the Viner aggregate supply function, according to which it’s only unexpected inflation that ever matters for anything…