That Smell in the Fed’s Elevator
A new paper that was presented last week at the 2017 U.S. Monetary Policy Forum has garnered, rightly, a lot of attention. The paper, entitled “Deflating Inflation Expectations: The Implications of Inflation’s Simple Dynamics,” has spawned news articles such as “Research undercuts Fed’s two favorite U.S. inflation tools”(Reuters) and “Everything the Market Thinks About Inflation Might Be Wrong,”(Wall Street Journal) the titles of which are a pretty decent summary of the impact of the article. I should note, because the WSJ didn’t, that the “five top economists” are Stephen Cecchetti, Michael Feroli, Peter Hooper, Anil Kashyap, and Kermit Schoenholtz, and the authors themselves summarize their work on the FiveThirtyEight blog here.
The main conclusion – but read the FiveThirtyEight summary to get it in their own words – is that the momentum of the inflation process is the most important variable (last year’s core inflation is the best predictor of this year’s core inflation), which is generally known, but after that they say that the exchange rate, M2 money supply growth, total nonfinancial credit growth, and U.S. financial conditions more broadly all matter more than labor market slack and inflation expectations.
Whoops! Who farted in the Fed’s elevator?
The Fed and other central banks have, for many years, relied predominantly on an understanding that inflation was caused by an economy running “too hot,” in that capacity utilization was too high and/or the unemployment rate too low. And, at least since the financial crisis, this understanding has been (like Lehman, actually) utterly bankrupt and obviously so. The chart below is a plain refutation of the notion that slack matters – although much less robust than the argument from the top economists. If slack matters, then why didn’t the greatest slack in a hundred years cause deflation in core prices? Or even get us at least close to deflation?
I’ve been talking about this for a long time. If you’ve been reading this blog for a while, you know that! Chapters 7-10 of my book “What’s Wrong With Money?: The Biggest Bubble of All” concerns the disconnect between models that work and the models the Fed (and most Wall Street economists) insist on using. In fact, the chart above is from page 91. I have talked about this at conferences and in front of clients until I am blue in the face, and have become accustomed to people in the audience staring at me like I have two heads. But the evidence is, and has long been, incontrovertible: the standard “expectations-augmented-Phillips-Curve” makes crappy predictions. And that means that it is a stupid way to manage monetary policy.
I am not alone in having this view, but until this paper came out there weren’t too many reputable people who agreed.
Now, I don’t agree with everything in this paper, and the authors acknowledge that since their analysis covers 1984-present, a period of mostly quiescent inflation, it may essentially overstate the persistence of inflation. I think that’s very likely; inflation seems to have long tails in that once it starts to rise, it tends to rise for some time. This isn’t mysterious if you use a monetary model that incorporates the feedback loop from interest rates to velocity, but the authors of this paper didn’t go that far. However, they went far enough. Hopefully, this stink bomb will at last cause some reflection in the halls of the Eccles building – reflection that has been resisted institutionally for a very long time.
 And that, my friends, is the first time I have ever used “crap” and “fart” in the same article – and hopefully the last. But my blood pressure is up, so cut me some slack.