Inflation risks and inflation expectations

U.S. inflation has been low and steady for three decades. This welcome stability is not merely a consequence of good fortune. Shocks that in the past might led to higher trend inflation—like the energy price increases—continue to buffet the economy much as they did in the 1970s and 1980s, when inflation rose to a peacetime record. Rather, it reflects the improved monetary policy of the Federal Reserve, which began acting as an inflation-targeting central bank in the mid-1980s, long before it announced a 2% target for inflation in 2012. As a consequence of the Fed’s sustained efforts, long-run inflation expectations have remained close to 2% for more than 20 years. One result is that temporary disturbances that drive inflation above or below target quickly fade.

This is the optimistic conclusion of the 2017 U.S. Monetary Policy Forum (USMPF) report. Since the adoption of the de facto inflation-targeting regime, one-off shocks have little impact on the inflation trend. Moreover, as many have observed, the relationship between unemployment and inflation—the Phillips curve (see our primer)—is now notably weaker. However, the authors of that earlier report warn that the Phillips curve “flattening” could be a direct consequence of the Fed’s success. Furthermore, since the sample period from 1984 to 2016 excludes any sustained period of a very tight economywide labor market, it would not be possible to detect an outsized impact, if any, of persistently low unemployment on inflation.

Enter the 2019 USMPF report, which focuses on the possibility that inflation may indeed respond differently when the unemployment rate is very low and projected to remain low for several years (see, for example the FOMC’s latest Summary of Economic Projections). The logic is straightforward: if labor is very scarce for an extended period, employers will bid up wages and (unless they are prepared to accept declining profits) pass on those cost increases in the form of higher prices….

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Bad Precedent

Recent reports that President Trump wanted to fire Board Chairman Powell in response to Federal Reserve interest rate hikes are unprecedented. Denials from senior officials―Treasury Secretary Mnuchin and Council of Economic Advisers Chairman Hassett―have even less credibility than would a statement (or tweet) from the President himself. We find this entire discussion extremely disheartening and surely damaging to economic policy and the credibility of the Federal Reserve. As former Chair Yellen has stated, the risk is that people lose “confidence in the Fed, in the basis for its actions and its responsiveness to its mandate” (see here, time mark: 18:51).

To be sure, there is some debate over whether the President can fire the Fed Chair, other than “for cause.” We are not lawyers, but thoughtful people such as Peter Conti-Brown suggest that the answer is yes. Against this background, we view President Trump’s actions (and reported wishes) as the most serious threat to Fed independence since the Treasury-Fed accord of March 1951….

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Inflation and Price Measurement: A Primer

People use a variety of statistics to gauge how the economy is doing. It is fairly straightforward to measure nominal GDP, so the challenge of estimating real economic growth arises from the need for accurate measures of prices. Price measurement also is key for inflation-targeting central bankers, who need a number as a guide and for public accountability. To be credible, that number must be based on an index constructed using established scientific methods.

Reflecting a set of well-known (and nearly insurmountable) difficulties, measured inflation has an upward bias. That is, the inflation numbers that statistical agencies report are consistently higher than the theoretical construct we would like to compute. As a consequence of this upward bias in inflation measurement, our estimates of growth in real output and real incomes are systematically too low.

The big question today is whether the bias in inflation measurement, and hence the bias in the measurement of growth, has increased in recent years. As Martin Feldstein describes in detail, the answer to this question is important, as it affects how we collectively view long-run progress. If published statistics show sluggish real growth, as well as slow growth in real wages and incomes, then people may be unduly pessimistic. A worsening bias would add to that pessimism.

In practice, however, careful recent analysis suggests that inflation measurement bias has not changed much since the early 2000s….

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Fiscal Sustainability: A Primer

Nobody likes taxes, so public spending frequently exceeds revenues, leading governments to borrow. These budget deficits are a flow that add to the stock of debt. Since the Great Financial Crisis of 2007-2009, public debt in a number of advanced economies has surged. In the United States. the Congressional Budget Office (CBO) recently projected that―in the absence of policy changes―federal debt held by the public is headed for record highs (as a ratio to GDP) in coming decades.

Importantly, there is a real (inflation-adjusted) limit to how much public debt a government can issue (see Sargent and Wallace). Beyond that limit, the consequences are outright default or, if the debt is in domestic currency bonds that the central bank acquires, inflation that erodes its real value leading to a partial default.

Ultimately, debt sustainability requires that a country’s ratio of public debt to GDP stabilize. Otherwise, debt eventually will rise above the real limit and trigger default or inflation. In this note, we derive and interpret a simple debt-sustainability condition. The condition states that the government primary surplus―the excess of government revenues over noninterest spending—must be at least as large as the stock of outstanding sovereign debt times the difference between the nominal interest rate the government has to pay and the rate of growth of nominal GDP. If it is not, then the ratio of debt to GDP will explode….

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Inflation Policy

Inflation in the United States remains at levels that most people don’t really notice. Overall, the consumer price index rose 2.8 percent from May 2017 to May 2018. And, when you look at core measures, the trend is still below 2 percent.

With inflation and inflation expectations still so benign, it is no wonder that despite solid economic growth and the lowest unemployment rate in 50 years the Federal Open Market Committee continues to act quite gradually (see their June 2018 statement). Inflation could well turn up in the near term—perhaps by more than the policymakers expect. But, for reasons that we will explain, if we were on the FOMC, we would stay the planned course: remain vigilant, but certainly not panic.

We start with a look at the data. What we see is that trend inflation has stayed reasonably close to the Fed’s medium-term target of 2 percent for the past two decades. There have been occasional deviations, like the temporary rise in 2008 and again in 2011, but overall, the path is remarkably stable….

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Time Consistency: A Primer

The problem of time consistency is one of the most profound in social science. With applications in areas ranging from economic policy to counterterrorism, it arises whenever the effectiveness of a policy today depends on the credibility of the commitment to implement that policy in the future.

For simplicity, we will define a time consistent policy as one where a future policymaker lacks the opportunity or the incentive to renege. Conversely, a policy lacks time consistency when a future policymaker has both the means and the motivation to break the commitment.

In this post, we describe the conceptual origins of time consistency. To emphasize its broad importance, we provide three economic examples—in monetary policy, prudential regulation, and tax policy—where the impact of the idea is especially notable....

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The Phillips Curve: A Primer

Economists have debated the relationship between inflation and unemployment at least since A.W. Phillips’s study of U.K. data from 1861 to 1957 was published 60 years ago. The idea that a tight or slack labor market should result in faster or slower wage gains seems like a natural corollary to standard economic thinking about how prices respond to deviations of demand from supply. But, over the years, disputes about this Phillips curve relationship have been and remain fierce.

As the U.S. labor market tightens, and unemployment approaches levels we have not seen in more than 15 years, the question is whether inflation is going to make a comeback. More broadly, how useful is the Phillips curve as a guide for Federal Reserve policymakers who wish to achieve a 2-percent inflation target over the long run?

To anticipate our conclusion, despite evidence of a negative relationship between wage inflation and unemployment, central banks ought not rely on a stable Phillips curve for setting monetary policy.

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The case for a higher inflation target gets stronger

For several years, economists and policymakers have been debating the wisdom of raising the inflation target. Today, roughly two-thirds of global GDP is produced in countries that are either de jure or de facto inflation targeters (see our earlier post). In most advanced economies, the target is (close to) 2 percent. Is 2 percent enough?

Advocates of raising the target believe that central banks need greater headroom to use conventional interest rate policy in battling business cycle downturns. More specifically, the case for a higher target is based on a desire to reduce the frequency and duration of zero-policy-rate episodes, avoiding the now well-known problems with unconventional policies (including balance sheet expansions that may prove difficult to reverse) and the limited scope for reducing policy rates below zero.

We have been reticent to endorse a higher inflation target. In our view, the most important counterargument is the enormous investment that central banks have made in making the 2-percent inflation target credible. Yet, several lines of empirical research recently have combined to boost the case for raising the target….

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The Fed's Price Stability Achievement

Over the past decade, critics of all stripes have assailed Federal Reserve monetary policy. At one end of the spectrum, some argued that the Fed’s expansionary balance sheet policy risked currency debasement and high inflation. While some of these critics sought merely to influence ongoing policy, others called for replacing the Fed altogether, and restoring the Gold Standard. And then there were those promoting oversight over monetary policy operations that would significantly curtail central bank independence.

At the other end, a different set of critics worried about outright deflation: according to monthly averages from Google Trends, since 2004, U.S. searches for deflation were twice as frequent as those for hyperinflation. Some economists called for a higher inflation target. Squarely in the second camp, officials inside the Federal Reserve System developed deflation probability trackers like this one (here is another from the Federal Reserve Bank of Atlanta).

These diverse perspectives form the backdrop to this year's report for the U.S Monetary Policy Forum (USMPF) that we co-authored with Michael Feroli, Peter Hooper and Anil Kashyap. In that paper, we document that the trend in U.S. inflation has been remarkably low and stable since the early 1990s....


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Inconvenient Facts

When governments don’t like the numbers their statisticians report, they have two options. They can modify their policies with the aim of changing the trajectory of the economy. Or, they can push to change the data to conform to what they would like to see. In countries with trustworthy leaders, those who understand the value of objective facts, we see the former. In places where leaders think that facts are a matter of opinion, we all-too-often see the latter. Finding some economic facts inconvenient, President Trump’s inclination appears to be to change the data, not his policies.

Two recent news reports have been particularly troubling, one having to do with trade statistics and the other concerning growth forecasts....

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Policy and Measurement

Policy, especially monetary policy, is about numbers. Is inflation close to target? How fast is the economy growing? What fraction of the workforce is employed?  And, what is the relationship between the policymakers’ tools and their objectives? Answering all of these questions requires measuring a broad array of economic indicators, with consumer prices high on the list. In this post, we discuss some of the pitfalls in measuring prices.

Price indices of the sort that we use today have been around since the late 19th century. In the United States, near the end of World War I, the National Industrial Conference Board starting constructing and publishing a cost-of-living index. This work was eventually taken over by the Bureau of Labor Statistics (BLS). Over the past century, the theory of price indexes (see, for example, here and here) and the means of measurement have both moved forward substantially.

With the advent of inflation targeting, price indices have taken on a new prominence. If monetary policymakers are going to focus on controlling inflation—setting numerical targets for which they are then held accountable—then the construction of the price index itself becomes an issue. What is included and how can become critical to the way policy is conducted and to the achievement of the stated objective, namely price stability....

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Inflation and Fiscal Policy

Why is it proving so difficult to raise inflation? For generations after World War II, this was not something that worried economists. Yet, today, even as central banks lower policy rates close to zero (or below) and expand their balance sheets beyond what anyone previously imagined possible (see chart), inflation remains stubbornly below target in most of the advanced world.

Nowhere is this problem more profound than in Japan, where mild deflation was the norm for nearly two decades and where inflation still remains well shy of the Bank of Japan’s 2% target. Even as monetary policymakers expanded the central bank’s balance sheet by nearly one-third of GDP and nudged its policy rate slightly below zero, consumer price inflation (as measured by our preferred trend measure, the 10% trimmed mean) has slipped from 0.9% to 0.1% over the two years to July 2016...

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The FOMC is coming

Having dropped to 5.1%, the unemployment rate has reached the longer-run employment goal of the Federal Reserve’s Open Market Committee (FOMC). So, starting to raise interest rates would seem to be in the cards. And, many observers expect policymakers to act soon, possibly very soon.

The key sticking point, and it is a big one, is that inflation – as measured by the personal consumption expenditure price index (PCE) favored by the FOMC – has been consistently below their stated 2% medium-term objective since early 2012.

Tightening monetary policy for the first time since 2006 requires confidence that inflation will in fact head back up (see, for example, the July FOMC statement and Fed Vice Chair Fischer’s recent comments). The difficulty is that confidence requires reliable forecasts. And, as it turns out, precise forecasts of inflation are hard to come by....

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What should Greece do?

Greece faces a stark choice: stay in the euro and implement the policies demanded by its creditors or exit and re-introduce its own national currency. The dimensions of this decision go far beyond economics, affecting Greece’s political and cultural identity for generations. Yet, even in a narrow sense – determining which option will lead to the best economic outcome for Greeks – the decision is complex and fraught with uncertainty...

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Are we overestimating inflation (again?)

Twenty years ago, a group of experts – the “Boskin Commission” – concluded that the U.S. consumer price index (CPI) systematically overstated inflation by 0.8 to 1.6 percentage points each year. Taking these findings to heart, the Bureau of Labor Statistics (BLS) got to work reducing this bias, so that by the mid-2000s, experts felt it had fallen by as much as half a percentage point.

We bring this up because there is a concern that as a consequence of the way in which we measure information technology (IT), health care, digital content and the like, the degree to which conventional indices overestimate inflation may have risen...

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Zero matters

The invention of the number zero transformed mathematics and laid the foundations for modern science. Zero is the additive identity (any number plus zero equals itself). It separates the positive and negative numbers. For a celebration of zero, see here.

Zero matters in economics, too.

Zero growth separates cyclical expansions and contractions. We need zeroes to measure the trillions of dollars of GDP, and even more zeroes to measure hyperinflations (during the record Hungarian inflation of 1945-46, the quantity of currency in circulation grew to a number with 27 zeroes). Most importantly, zero (or slightly less) marks the lower bound on nominal interest rates and a downward barrier for wage changes...

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Should we really worry about currency wars?

In September 2010, Brazil’s former finance minister, Guido Mantega, made headlines when he accused the Federal Reserve, the European Central Bank and the Bank of England of engaging in a currency war.  The complaint was that easy monetary policy was driving down the value of the dollar, the euro and the pound, at the expense of his country and those like it. More recently, similar charges have been levied against Japan: namely, that the Bank of Japan’s extraordinary balance sheet expansion is aimed at driving down the value of the yen, damaging the country’s trading partners and competitors...

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Your Friend FRED

“Captain, we’re here. Why not avail ourselves of this opportunity for study? … No other vessel has been out this far.” Lt. Commander Data, Star Trek: The Next Generation, “Where No One Has Gone Before” (1987)

If you are a student of economics – or an inquisitive android like Lt. Commander Data of Star Trek: TNG fame – then you have a great friend to help you understand the world: FRED.  The Federal Reserve Economic Database (FRED for short) is provided free of charge to the public by the Federal Reserve Bank of St. Louis. FRED currently includes more than 238,000 time series from nearly 80 sources covering about 200 countries, and it continues to grow...

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Measuring inflation: Signal extraction redux

Not long ago, we posted a commentary discussing the difficulty of interpreting GDP data. The problem is one of extracting the true signal of economic growth from the noisy way that we measure output.

This signal extraction problem is generic in economics (and other sciences that use statistics). Indeed, one of us began his professional career trying to discern the trend of U.S. inflation. It was 1980 and the inflation numbers were hitting a peak of nearly 20%. The standard operating procedure at the time was to take things like food, energy and some housing-related items out of the index and recalculate them. But that meant removing only the components that had gone up more than average! How could you justify that?

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How much is our distant future worth?

In the first Superman movie, released in 1978, Lex Luthor, the supervillain played by Gene Hackman, buys up large swaths of real estate in the deserts of eastern California and Nevada. His plan is to hijack a nuclear missile and use it to cleave off coastal California into the Pacific Ocean, leaving him with newly valuable beach-front property. Well, maybe all Lex really needed was patience, not a nuclear device...

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