I’ve got a piece over at WaPo that OTE’ers might enjoy on the Fed’s 5, 3, 2 problem. As in their unemployment and interest rate targets (~5 and 3 percent) are too high and their inflation target (2 percent) is too low.
Let’s talk about this last bit—the inflation target—a bit more, though this conversation also applies to the other stuff in the piece, as you’ll see.
First, and this isn’t the main point of this post, but a bit of venting. Actually, never mind—I dealt with this through a cathartic tweet (the 2% target is an average, not a ceiling! Can I please get some symmetry!).
The actual point of this post is just to reflect a bit more on the phlat Phillips Curve (PC), as shown in this recent analysis by Fed economist Michael Kiley (whose work on all this is thoughtful and compelling). One of Kiley’s figures, below, shows the extent to which the PC has flattened in recent years.
The question is “why so phlat?” and one answer that I don’t get into in my WaPo piece is that the Fed has gotten really good at convincing everyone that damn it, inflation is going to stay low and stable and that’s all there is to it. In Fed-speak, that’s saying “inflationary expectations are well-anchored” around their target of 2%.
Kiley and others provide some evidence to that effect, but what’s interesting to me is how this explains important findings like these which show the collapse of traditional statistical measures that used to explain the variance in inflation using measures of economic slack.
A friend provides a useful analogy: Trying to estimate the PC these days is a little like testing the impact of outside temperature changes on an inside room that’s climate controlled. You’re not going to pick up a lot of variance because the climate is effectively controlled by the thermostat. If you, say, regress the inside room temperature on the outside temp, your coefficient will wiggle around zero, because the thermostat is doing its job.
In other words, the PC is flat because the Fed is effectively controlling inflation.
This seems convincing (if it sounds really obvious, I assure you, as an old person, that wasn’t always the case) but one would like to disprove other explanations, especially since the extent of the anchoring would have be really strong to explain how little inflation has responded to output gaps either when they were really very large or when they were closing pretty quickly. Kiley takes you through numerous other suggested explanations, including basic rigidities in prices and wages.
But I’ve always wondered if there’s a globalization piece to all this. Surely increased global supply chains put downward pressure on prices. Also, inequality, low worker bargaining clout, and the decrease in collective bargaining have long diminished the link between productivity and real wages…and perhaps prices as well.
Last point: as I stress in the WaPo piece, the inflation target is too low—at 2%, it invokes possible zero-lower-bound problems the next time we hit a downturn, and especially with a…um…difficult Congress (meaning adequate countercyclical fiscal policy may well not be forthcoming), that’s a really serious problem.
If they can anchor so effectively at 2%, why not 4%?