About those "traditional models"
By Scott Sumner
The Financial Times has an article discussing the Fed’s concern over persistently low inflation readings:
The Fed’s favoured inflation measures have averaged just 1.5 per cent during the current expansion.
With the US recovery 10 years old and unemployment near half-century lows, traditional models suggest inflation should be surging, but instead it has remained surprisingly tepid.
I really wish they had said “traditional Keynesian models”, because that’s what they are talking about. When Milton Friedman developed the Natural Rate Hypothesis, he did not make the mistake of assuming that you could predict inflation from economic growth data, nor did he argue that inflation was caused by excessive growth. Friedman understood that inflation is caused by expansionary monetary policy.
That’s not to say his views were perfect; he put too much weight on money supply growth data. But Friedman’s overall framework was much superior to the Keynesian approach. He argued that higher than expected inflation could raise output in the short run. It was Keynesian economists who made the mistake of reversing the direction of causation. They developed the NAIRU theory, the idea that strong growth causes rising inflation. This is an example of reasoning from a quantity change—trying to predict prices by looking at changes in Q, without first asking whether the change in Q was driven by a change in supply or a change in demand. The NAIRU theory should have been discredited in the late 1990s, when a booming economy did not lead to high inflation. But this zombie model persists even today, despite the fact that it doesn’t match the evidence.
In fact, the economy can adjust to almost any persistent inflation rate. The public has adjusted to years of 1.5% inflation, and unemployment has returned to its natural rate. But a booming economy does not cause inflation; indeed other things equal, economic growth actually reduces inflation if it’s driven by supply-side factors.
Market monetarists reject the old monetarist focus on the money supply and prefer to look at market forecasts of inflation, which have shown no evidence of an outbreak of high inflation. Indicators such as TIPS spreads certainly are not perfect; indeed I’ve argued they can be slightly biased by oil price shocks and changing risk premia. But these distortions are a few tenths of a percent, and don’t change the fundamental picture; high inflation is unlikely in the near future, despite extremely low unemployment rates.
Why does the Financial Times call a traditional Keynesian model a “traditional model”? I think it’s because they and most other media outlets see the world through a Keynesian lens. It’s the same reason they assume that fiscal stimulus boosts output. Many pundits don’t know that there are much better models of the economy available than what they learned in their textbooks.