James Hamilton at econbrowser has a fascinating post titled, “Why isn’t inflation lower?”
He presents a paper titled, Is The Phillips Curve Alive and Well After All? Inflation Expectations and the Missing Disinflation, written by Olivier Coibion at UT Austin and NBER and Yuriy Gorodnichenko at UC Berkeley and NBER.
It would not be easy to summarize the post, so I will just take a snip-it from the abstract of the paper to give you an idea.
“If firms’ inflation expectations track those of households, then the missing disinflation can be explained by the rise in their inflation expectations between 2009 and 2011.”
The logic is that we did not have as much “disinflation or deflation” as might have been predicted between 2009 and 2011, because households were expecting inflation due to oil price increases.
In addition, they give a model of the Phillip’s curve that is consistent through the decades. That is really good work.
James Hamilton makes 3 wonderful conclusions at the end of his post as to why then it would be difficult for the Fed to stimulate the economy. . I want to respond to them.
1. “First, it makes it much more difficult for the Fed to try to justify its actions to the public on the grounds that inflation is currently too low.”
It seems that people do not connect with “Fed-speak”. People are on another page. They don’t measure inflation without food and energy as the Fed does.
2. “Second, if makes it harder for the Fed to stimulate the economy without raising inflation, particularly if one byproduct of stimulus efforts is an increase in the relative price of oil.”
I start from the premise that the Fed cannot raise inflation because there is no transmission mechanism to put more money in the hands of labor. People may be expecting more inflation without much ability to afford it. This creates insecurity. They resist higher prices even as they expect them.
3. “Third, it implies that ex ante real interest rates, if we base that concept on the perceptions of large numbers of economically important decision makers, are extremely negative at the moment, casting doubt on the claim that a primary policy objective should be to make them even more negative.”
Exactly… This is a profound conclusion with a weird twist of logic. Raising inflation would lower the real interest rate. Yet, higher expectations of inflation imply a lower real interest rate already. And still there is little budge to markedly improve employment and output. Even if inflation rose, it might not change the expected real interest rate, or it might snowball into higher and higher expected inflation.
People have no return on their savings. They are afraid to spend money because they see their balances going down. Normally when interest rates are held low, people are supposed to put money into cash and then spend it. But we see that people are not spending their cash. Why? They resist spending cash when there is no return on their savings. People are insecure about the future. People need to feel some return on their savings in order to feel secure about spending a little more. So it makes sense for the Fed to raise the interest rate, in order to raise returns on savings, and encourage people to spend more money to raise output.
The logic then is for the Fed to raise the interest rate in order to coax real output up…. and to heck with the immature and immediate reaction in the financial markets. They will learn to deal with it once they see balance returning to economic output.
Strange logic we are in nowadays…
I will end with an intriguing sentence from the paper by Coibion and Gorodnichenko.
“Regardless of the methodology employed, successfully characterizing how firms form their expectations strikes us as central to understanding more deeply the link between the nominal and real sides of the economy.”
In many situations, expectations are irrational. One cannot effectively deal with irrational expectations by being rational. One has to be willing to perceive an irrational solution as being rational.