What if the Fed is just really good with anchors?

August 22nd, 2016 at 11:30 am

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.

Source: Michael Kiley

Source: Michael Kiley

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%?

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7 comments in reply to "What if the Fed is just really good with anchors?"

  1. Another Scott says:

    Is there a clear explanation anywhere of what the actual metric is that the Federal Reserve is targeting for “2% inflation”? It’s clearly not CPI or PPI, it doesn’t seem to be the GDP Deflator. CalculatedRiskBlog keeps track of 2-3 of them but it’s never really clear what Janet and the BoG are targeting.

    Why is this so nebulous? Why is it not made clear by the Fed that the “target” is not a hard limit but an average (over what period of time?) if it is an average? They seem to be hyper-sensitive about signaling changes in interest rate policy, but they seem to not care about the ambiguity and contradictions in the reporting on the actual metrics that they use to determine whether to change the policy or not. It’s maddening!

    Maybe they’re between a rock and a hard place. Maybe they want to say that the “2% inflation target” is actually a 2 year average and blips of 5% for a month or a quarter won’t cause them to freak out. But maybe they can’t say that because the Congress would have them thrown in the stocks, or something. If that is the case, why isn’t there “insider reporting” on that aspect of the policy decisions? As it stands now, as the various inflation metrics approach 2%, they seem to be tying their own hands, forcing themselves to tighten even if wages are still mostly flat and even if households are still hurting in much of the country.



    • Jared Bernstein says:

      Generally, the 2% inflation target refers to the PCE deflator (yr/yr change). But because oil prices have tanked so much and they’re thought to be set on global markets–so not really under the Fed’s control–recently they’ve been targeting the core PCE (sans energy and food prices).

      • Smith says:

        “Oil prices have more than halved from mid-2014 due to a global supply glut.”

        “The global benchmark rallied 20 percent between the beginning of the month and Aug. 19.”

        If that 20% holds, it adds nearly a full percentage point to annual inflation measured for August. 20% projected for 12 months =120% which adds 1% to total inflation for all consumption or expenditures. Of course oil is not going to continue at that pace, it’s dropping already. But one sees what could happen depending on the timing of a month’s rise, the Fed meetings, and propaganda from bankers and politicians, mostly Republicans.

  2. Smith says:

    It’s insane to treat 2% as a ceiling, it shouldn’t even be the average. Look at the historical record. Unemployment below 5% and inflation at or below 2%? 1998 and 1965 and 1956. Moreover, inflation was much higher in the recovery years of the 1980s and 1990s when real wages grew.

    But to answer the question with an obvious if unscientific observation…
    It’s harder to anchor at 4%. Higher inflation is much harder to anchor. Here is a simple intuitive reason why. At 2% it’s hard to notice price increases, and this further eases the anchoring as the average Joe swallows a 2% nominal raise, partly due to weak economy, without noticing it’s no raise at all. 15 years later, his wages are stagnant or below what they used to be. But at 4% and more so if inflation is higher, you’d better believe people would notice everything costs more. Ok, maybe not the first year, but give it two years and you’ve got 8% to 10%. Meanwhile the boss is still offering the originally inadequate 2% raise, saying he’s being squeezed by inflated costs. Maybe. In our uncompetitive world, more likely business raises prices beyond the rate to short sightedly justify a hike claiming inflation and worker’s wage demands are to blame. Add a one time price shock like oil, and it doesn’t have to be 1978 magnitude to be significant, and away we go. One needs to find a natural experiment, is there a threshold crossed where people notice higher prices, 2% a year, no, 5% a year yes? or 4% after two years no, 10% after two years, yes.

    • NoPolitician says:

      I feel the same way. As inflation is held so low, people can hold on to their conception of what things “should be” for far too long. A doughnut “should be” $1 because that’s what it has been for so long. A bottle of soda “should be” $1.69. It has been this for so long that to change it would cause outrage, even if those prices really need to change due to slowly creeping inflation. In response to that pressure to keep things as they “should be”, companies cut corners, they make things worse for everyone (maybe making things a little smaller, or doing stupid stuff like making the donuts a week in advance and freezing them).

      An inverse example is with asset prices. A guy bought a house 20 years ago for $200k. Inflation of 2% over 20 years means that it “should be” worth $290k. Maybe the guy hasn’t made improvements on it, so the market says it is worth $225k. Will that guy be happy to sell? Absolutely not, he has owned it for 20 years, he wonders why it isn’t it worth more? $225k is basically the same number to him today as it was 20 years ago.

      If there was an inflation rate of 5%, that house now can sell for $500k. He would be thrilled to sell for $500k because he only paid $200k for the asset. It doesn’t matter that he is no worse off under each scenario, selling something for more than twice what you paid for it feels a lot better than selling something for 25% more than what you paid for it.

      Raising inflation would make people more uncomfortable, but I think decoupling people from price certainty will open things up.

  3. Blissex says:

    A target of 4% “inflation” a or new policy regime of NGDP targeting at some level may be good ideas, but they have a very large “path-dependency” flaw.

    *Switching* to them from a target of 2% “inflation” to 4% “inflation” or to a regime of NGDP targeting would cause a massive bond crash, and a colossal financial system crash, as the AAA bonds that are the basis of immense rehypothetication/collateral chains get repriced and bust a lot of balance sheets.

    There is a profound asymmetry between ever lower inflation and nominal interest rates and viceversa: a bond boom usually has many beneficiaries, and only threatens the solvency of pension funds, but a bond crash has many more losers.

    So a switch will only be possible during a very serious crisis, much bigger than 2008.

    • Blissex says:

      «*Switching* to them from a target of 2% “inflation” to 4% “inflation” or to a regime of NGDP targeting»

      I think I found a simple way to illustrate the asymmetry: switching to a 4% “inflation” target from a 6% inflation targets results in a bond boom, from 2% to 4% in a bond crash. A bond boom does not result in an immediate crisis, a bond crash does.