Is the Fed fighting an old war?

June 15th, 2017 at 12:18 am

As expected, as their meeting concluded yesterday, Federal Reserve Chair Janet Yellen and company decided to raise the benchmark interest rate they control by one-quarter of a percentage point. The question is: why?

She was, of course, asked about this in lots of different ways in her press conference. [Pause here for a moment and consider the substantive difference between a Yellen press conference and a Spicer press conference. Kinda makes you shudder.] Specifically, journalists reasonably wanted to know what was up with the rate hikes given how low inflation has been. Sure, we’re closing in on full employment, but the Fed’s preferred inflation gauge, the core PCE, is below their 2 percent inflation target and slowing. It’s decelerated from 1.8 percent in the first two months of this year to 1.6 percent in the last two months. Expectations remain low–under 2 percent–as well. That’s the opposite of what you’d expect if tight labor markets were juicing price growth, and a legitimate reason not to tap the growth brakes with another rate bump.

Chair Yellen, as you’d expect, made a coherent case about not getting “behind the curve” and thus tapping the brakes now to avoid slamming them later. She talked about one-time factors dampening price growth, predicting that as soon as these faded, inflation would firm up and begin to reflect the tight labor market.

Coherent, but not very convincing. Economist Joe Gagnon, though he considers the rate hike to be “reasonable” based on other indicators he cites, bemoaned the ad-hockery of the Fed’s inflation analysis:

Is the FOMC revisiting the bad old days of the 1970s, when it tried to explain away inflation that was too high by pointing to a seemingly endless stream of one-off factors? The [core PCE] already excludes volatile food and energy prices. We certainly do not want to get on the slippery slope of excluding ever more categories with price movements the FOMC does not like.

A bit of ad-hockery and one-offery might be okay but for the following picture. The black line is the Q4/Q4 change in the core PCE, and the dotted lines are the Fed’s projections of future inflation with each projection labeled by its date of publication (I left a few out for clarity, but they followed the same pattern). It’s a pretty clear picture of hope over experience. The Fed keeps projecting that inflation will climb to their 2 percent target, while actual inflation keeps ignoring their predictions.

Sources: BEA, Fed

This suggests a problem with the model. One theory is that big, structural changes in trade and technology have permanently lowered the rate of price growth. But economist David Mericle from Goldman Sachs (no link) looks at trade, the internet, and productivity growth and finds they fail to explain much of the “hope-over-experience” pattern above. Import penetration from countries that export relatively cheap goods to us remains high compared to where it was 20 years ago, but it has actually come down in the past few years. Yes, we’re buying a ton more stuff online, but online prices don’t diverge that much from other prices, at least as measured by our deflators (Mericle cites “outlet bias,” meaning the indexes don’t always record when consumers switch to cheaper online sellers). Finally, it’s awfully hard to tell an accelerating productivity story when productivity growth has slowed over the very period wherein the Fed’s been consistently missing their target to the downside.

So, what’s going on with inflation? If the Fed can’t figure it out, I doubt I’ll be able to do so. Gagnon points out that the recent decline in the dollar should nudge inflation up a bit. Mericle’s points are all well taken, but perhaps when you add structural changes together, their whole is bigger than the sum of their parts.

Another thing to consider is that while we’re surely closing in on full employment, there are signs that we’re not there yet. Pockets of weakness persist for some less advantaged groups and in some parts of the country, a point Chair Yellen herself recently made, and even nationally, there’s not all that much wage pressure. Worker bargaining power looks lower than I might have expected at 4.3 percent unemployment. Empirically, the links in the chain between tight labor markets, wage pressure, and price pressure appear much weaker than they were decades ago, a point Ben Spielberg underscores in the recent podcast we did on the Federal Reserve (which some have found surprisingly entertaining!). It’s very important not to fight old wars.

For the record, Janet Yellen has long been a stalwart slack fighter, at least before she and most of the others decided: “enough already with the data-driven thing—it’s time to get rates back up to normal levels.” The problem is that figure above suggests there may well be a new normal, one to which the old benchmarks don’t apply. On the basis of that possibility, I’d urge the members of the committee to put down the old maps and look out the window. It’s a different world out there.

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12 comments in reply to "Is the Fed fighting an old war?"

  1. AngloSaxon says:

    Core PCE has been below 2% since the mid-90’s. There is no “old war”. Where was the slack then? Maybe, just maybe, Core PCE doesn’t matter to slack on how it is calculated. Maybe, Core PCE is simply irrelevant.


  2. Bobby Sinclair says:

    Refiners created to much gas last year into early this year. This is partially why BLS non-sup wages fell off in March and flattened(the other was the reduced number of day. It is just another price deflation that will end soon enough in energy. Demand is amping for the summer of course, but that will just correct the imbalance. I suspect refineries will shut down with extra vacation time in July/August.

    Frankly, as the reserve currency of the world, it is close to impossible to have inflation. The only time the US has had inflation since 1945 was during Nam and the unchaining of BW in the late 60’s. I thought we were frankly over this in the 00’s in terms of understanding this. Tighten the labor market all you want, it won’t matter. It won’t produce inflation because the reserve currency is like profit booster. It makes doing business easy and credit pours in boosting profit and deflating prices.

    The Fed lies in this case. They are more scared of credit bubbles than anything else.


  3. Larry Signor says:

    Let’s not forget what the Fed is. It is basically an association of bankers whose institutions make their profits from interest arbitrage. This gives its’ members a vested interest (pun intended) in raising rates.


  4. spencer says:

    Both the BEA estimates of consumer spending and of retail sales shows that online purchases have been growing faster than other areas over the past decade and that online prices have been falling one to two percentage points per year. Maybe they are underestimating its growth but the data is showing a strong impact from online sales.
    Moreover,it it a major reason behind the problems many traditional retailers are experiencing.

    Trend real growth of e-commerce is about 15% in the data.


    • Smith says:

      While your attention is drawn to the crazy way we regulate inflation, let me point out the entire process is wrong. Inflation should not be controlled by raising interest rates in order to slow the economy and wage growth. This is a recipe for stagnant wages and slow growth, like in the 2000s before the recession. Was that secular stagnation? Secular shmecular, it’s just killing the economy in order to save it. You are leaching. Economists are no more the 18th century physicians. Are there other causes of inflation besides wage growth? Yes. Other there other ways to control inflation? Yes. That’s even before we get into the fact 2% inflation target is too low and doesn’t match any sustained historical record of prosperity in the last 60 years.
      This blog quibbles over a point here and a few months there, while the whole process and way of thinking reeks. It’s not scientific, it’s not logical, it can’t be substantiated by models. Your Phillips curve, Taylor rule, and NAIRU are crap. Admit it.


      • Smith says:

        *Economists are no more than the 18th century physicians. (left out “than”)


      • Jared Bernstein says:

        OK, I’ll take some of the bait.
        NAIRU: Unidentifiable with any degree of accuracy so worse than “crap”–dangerous.

        Phil Curve: Totally broken for lo these many years (so, like NAIRU, a misleading guidepost), but there is an historical correlation between unemp and inflation which is worth measuring, monitoring. Crap? Maybe not.

        Taylor rule: Not crap! I’ve got a big piece on this coming out. It (the T-rule) usefully describes Fed policy over many years so it conveys important info. But, by itself, a thoroughly incomplete and ambiguous guidepost to forward-looking monetary policy.


        • Smith says:

          What I’m trying to demolish is the view that interest rates should control inflation. I’d like the debate to move towards discussing the alternatives. It seemed logical to begin by discrediting current harmful policy, but that’s not where I want to focus attention.

          Yes the Taylor Rule is important if it predicts Fed policy. That doesn’t mean it is good policy or should be followed. But readers may be confused, and think it attempts to describe some economic phenomena, like supply and demand. As you point out, it’s made up rule intended to guide those in power. As an aside, perhaps just one important indicator, the maker of this rule, though wikipedia predicts an eventual Nobel, is a nutcase, full of rational expectations, promoting a flat income tax, and arguing against fiscal stimulus (see WSJ article below).

          Could raising interest rates ever be a useful tool in combating or controlling inflation? Yes, of course. But should we be discussing the real causes of inflation? Hint: it’s not low interest rates, growth, or higher wages. Uhmm, maybe it has something to do with prices. We should also not lose track of finding a historically valid inflation target (not 2%) What about ways to combat inflation without throttling growth? The ACA, fracking, monopolistic pricing, inequality, productivity, slack, overskilled workforce, the internet (as cited above by Spencer) all have effects. Dean Baker cites the lunacy of raising the cost of housing when rising rents are a major factor in the tiny inflation we do have. There wouldn’t be a an asset bubble either if growth and wages fueled inflation and that led to an interest rate rise.

          If Verdoorn was correct, we need greater growth, not less.

          Here is Taylor with another rule:
          “The Obama Stimulus Impact? Zero”
          “Liberals are still arguing that the federal spending stimulus wasn’t large enough. How many multiples of nothing—its result according to new evidence—would they like?”
          “By John F. Cogan And John B. Taylor
          Updated Dec. 9, 2010 12:01 a.m. ET “


      • Bobby Sinclair says:

        Wage growth doesn’t cause inflation, inflation causes wage growth.


    • Smith says:

      Oops, that reply decrying the state of economics was meant to be a comment in its own right. The point about e-commerce is very interesting and should be explored further, and adds to evidence even mainstream economists (like Yellen) don’t know what they’re doing.


  5. Roger C says:

    If I don’t understand why it’s happening, then it isn’t happening.


  6. The Fed’s problem with inflation | Bruegel says:

    […] Jared Bernstein also wonders whether the Fed is fighting an old war. Sure the US is closing in on full employment, but the Fed’s preferred inflation gauge, the core PCE, is below the 2 percent inflation target and slowing. It’s decelerated from 1.8 percent in the first two months of this year to 1.6 percent in the last two months. Expectations remain low–under 2 percent–as well. That’s the opposite of what you’d expect if tight labor markets were driving price growth, and a legitimate reason not to tap the growth brakes with another rate bump. Chair Yellen made a case about not getting “behind the curve”, but Bernstein believes this was not very convincing. Looking at the Fed’s projections of future inflation over time, Bernstein argues that the Fed keeps projecting that inflation will climb to the 2 percent target, but actual inflation keeps ignoring their predictions. This suggests a problem with the model. […]


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