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.
READER COMMENTS
Ahmed Fares
Feb 23 2019 at 4:49pm
The lack of inflation can be easily explained by the Global Slack Hypothesis. In a global economy, what matters is global slack, not domestic slack.
There are two competing explanations for the demise of the standard, domestic, accelerationist Phillips curve. The first is that because inflation expectations have become firmly anchored at the target (no one doubts the Fed’s willingness or ability to keep inflation in check), the inflation process has mutated so that the relationship that works now is between domestic slack and the level of inflation rather than changes in inflation. There is some evidence to support this hypothesis. See Figure 2. The competing explanation is the Global Slack Hypothesis which says that due to the integration of global markets, what now drives inflation is not domestic slack but rather global slack. Due to competition from global rivals, domestic producers in the tradable sector cannot raise prices when the domestic labor market tightens and wage pressures build. Instead, they either rebalance their global supply chains and off-shore production; or they lose business to their foreign rivals. In either case, domestic inflation is determined as much by global slack as by domestic slack.
The evidence is mounting that the second explanation is the right one. What is especially compelling is the evidence that global slack is statistically significant in ALL countries for which data is available while domestic slack is significant is NONE since 2000. See Figure 3. The last column corresponds to global slack (“foreign gap”); no stars means the variable is not significant; three means it is significant at the 1 percent level.’ —quoted from an internet comment
Scott Sumner
Feb 23 2019 at 5:40pm
Global slack? I don’t think so. Check out the inflation rate in Venezuela. Inflation rates vary according to national monetary polices.
Ahmed Fares
Feb 24 2019 at 12:45am
Venezuela is a poor example to use. It’s not even a market economy anymore. They set prices below the cost of production and then this happens:
Market shelves in the scruffy Colombian town of Puerto Santander are loaded with Venezuelan maize flour, rice, cheese spread and more, heavily subsidized consumer goods smuggled by government officials and ordinary citizens alike and sold at big mark-ups. Gasoline is ferried from Venezuela too, as people cash in on the arbitrage opportunities created by extreme price distortions.
The spectacle of food being spirited out of a country where hunger is becoming epidemic shows in microcosm how Maduro’s socialist government has created an economic and humanitarian disaster. While this black-market trade has been going on for years now, it’s jarring to witness it at a time when much of the world has thrown its support behind efforts by Maduro’s rival, Juan Guaido, to bring emergency supplies into the country.
“It makes you angry to see these products for sale,” said Lisbeth Cisneros, 28, a pregnant mother of four who fled the Venezuelan town of San Cristobal three months ago and works as a street vendor on the Colombian side of the border. “The situation is horrible over there.” —Bloomberg
This is not a problem that fiscal or monetary policy can cure. They just have to stop doing stupid things. You know, Econ 101 stuff.
Scott Sumner
Feb 24 2019 at 3:14pm
Ahmed, They have hyperinflation because they print too much money. Period. End of story.
Shortages are caused by price controls.
Benjamin Cole
Feb 23 2019 at 7:45pm
Global slack ?
I would not toss the baby out with the bathwater just because of the Venezuela, Zimbabwe or possibly Turkey.
The major economies have a great deal of trade going on. In fact a higher price signal in one nation for a particular commodity, say wheat, will attract wheat from around the world, including from the low-cost producer Germany.
Many industries suffer from chronic over-capacity, such as automobiles, iron and steel, aluminum and nearly all agricultural commodities. Even smart phones.
Here is a report this week from Fitch Ratings:
“Fitch believes a glut of uneconomic production, due to the Chinese government subsidizing new primary metal production operations and semi-fabricated products, could further destabilize aluminum prices and industry cash flow.”
Are we really to believe that new aluminum production from China will not lower aluminum prices and thus feed into US reported inflation rates? (unless tariffs…).
In the range of industries that are becoming glutted with suppliers is expanding, would that not have a disinflationary effect?
Of course, monetary policy plays the driving role in US inflation rates. But there are huge structural impediments or institutional rigidities to take into account, as well as globalization.
Prices may be distorted, inflated or even made inflationary by, say, ubiquitous property zoning that is not static but essentially growing tighter over time.
Probably the Keynesians are wrong, although I still think the best position in macroeconomics is that no one is ever wrong.
Ahmed Fares
Feb 24 2019 at 1:54am
Like Venezuela, Zimbabwe is a special case.
Inflation is defined as too much money chasing too few goods. In the case of Zimbabwe, the problems started when the government broke up the large white-owned farms and distributed them in small plots to black farmers in the interest of social justice. Without mechanized agriculture and losing economies of scale, there was not enough food to feed the cities. This is an example of inflation caused by too few goods, not money printing. The money printing stupidity started later.
Zimbabwe would have had hyperinflation even without money printing.
Benjamin Cole
Feb 24 2019 at 4:09am
Ahmed–
Perhaps Zimbabwe would have had inflation, with their farm land redistribution schemes. But hyperinflation?
I agree (and so does George Selgin) that inflation is not always a monetary phenomenon; that is, a reduction in supply—say a crop bust in an agricultural economy—can lead to higher prices as measured (and indeed, in this case tightening up the money supply could have adverse effects),
In the US, perpetually tightening housing markets along the West Coast and some other markets (due to property zoning) are measured as “inflation.”
In general, I think globalization (for the US) can be thought of as a continuous stream of positive supply shocks in the past 40 years. Large flows of labor into the US did the same. Recent reports from IHS Markit and Fitch suggest China is actually upping its game in terms of subsidizing industry.
However, there is also another $1 trillion of capital seeking a home in the US every couple years, axiomatically due to chronic and large current-account trade deficits. The IMF says this inflow bloats asset prices, which then can collapse…as when the Fed tightens up to fight wage growth. The Hyman Minsky moment.
If inflation ever does get above 2%, it will be fascinating to watch the Fed response. What if the choices are higher-than-target inflation or another Great Recession?
Jason S.
Feb 25 2019 at 3:46pm
Trade affects relative prices, not the general price level.(*) If the Chinese make more aluminum (supply schedule shifts out), then the price of aluminum relative to other products will fall. But the general price level remains the same.
(*) Exception: If trade increases due to an increase in productivity or the removal of barriers to trade, then aggregate supply shifts out and the general price level falls. But if this were what is happening globally, then you should see abnormally high real GDP growth rates, which you don’t see either.
Benjamin Cole
Feb 24 2019 at 12:03am
Add on:
I ponder global capital markets. It appears capital easily flows across borders. It also appears there are vast amounts of capital “on the sidelines” in bank accounts, including offshore bank accounts-tax havens. By one estimate, $32 trillion.
So…when a particular central bank engages in QE, what is the result?
By some estimates, global bond markets are north of $100 billion, and equities another $30 to $40 billion. Double that combined number to $280 trillion or so if one wishes to count property as an asset. It is (famously or infamously) a securitizable asset.
So, let us say the Fed buys $4 trillion in bonds. So? But, of course, the BoJ and the ECB are also buying bonds. But global debt is being issued also, continuously. Long-term rates are set by the market.
So can we confidently state QE will work, on any scale that the Fed dares?
It does strike me that, given that if capital markets are in fact globalized and gigantic, then a particular central bank has the option of buying back (essentially monetizing) national debt without inflationary consequence. This seems sneaky, but it also seems to be what is happening.
I guess no one expects the Bank of Japan to ever sell its balance sheet. But Japan has inflation trapped under 1%.
Michael Sandifer
Feb 24 2019 at 9:39am
Scott,
Doesn’t the change in the unemployment rate depend upon the difference in the growth rate of NGDP and measures like the ECI? Hence, aren’t there multiple natural rates of unemployment, when real GDP growth is below potential? Since US productivity growth is low, labor compensation growth is low, and unemployment can continue falling to very low levels.
With looser money, investment could increase, boosting productivity and gains in growth of labor compensation, toward a more favorable low unemployment equilibrium.
Scott Sumner
Feb 24 2019 at 3:17pm
Michael, I believe it’s best to think in terms of a single natural rate, the unemployment rate that would occur if NGDP was equal to expectations. Now of course this changes over time, with investment shocks, etc., as you say.
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