Tuesday, September 29, 2015

Clarida on Fed policy: or how does the Fed affect inflation

Richard Clarida gave an interview (right at the beginning of the podcast) on why the Fed should increase the rate of interest. He also said that the Fed can affect inflation, which, he correctly points out, is denied by several economists. However, the degree of confusion on this subject is significant, and modern monetary theory, and its implications for central banking behavior, is, in part, responsible for that.

The conventional wisdom on what central banks can do (and one can think of Clarida's contribution with Galí and Gentler as a good summary of the dominant position) suggests that central banks can only target inflation efficiently in the absence of cost-push inflation or if they do not care about deviations from the natural rate of unemployment (or output, depending on whether the unemployment gap or the output gap is used for the central bank's policy rule). And some authors believe that inflation is in the long run really always caused by excess demand, and that the system gets back to its natural level, so that there should be no concern other than inflation.

Under these circumstances the Fed has an effect on inflation through two mechanisms.The Fed could maintain the rate of interest low even in the face of an economy close or in extremis at the natural rate, supposedly stimulating spending, and it could also affect inflationary expectations. The later is the basis for Blanchard's proposal to increase the inflation target to 4%, for example. The same solution was suggested by Krugman (my comments here).

On the first issue, besides the problem that most mainstream economists do not know what is the precise level of the natural rate of unemployment (and I'm not even going to get into the logical problems which the rate), there is the issue that the natural rate is not constant, and it might be affected by the actual level of unemployment. So as the Fed keeps the rate low, and again this would arguably lead to more spending, higher output and lower unemployment, the natural rate would fall, and inflation might not pick up.* In addition, there is the fact that lower rates might not translate into higher private spending after all. Eccles famous 'pushing on a string' story. In that case, it seems that the Fed has actually limited capacity to affect inflation.

The second point emphasis the role of expectations. The notion is that the Fed affects what agents think and has real effects through this channel. This is a variation of the inflation expectations fairy according to which higher expected inflation would lead to more investment. Here again Eccles is relevant. Eccles was very explicitly against confidence fairy type arguments (see here and here). Here the argument is that if the Fed announces its willingness to allow for higher inflation, then agents would assume that inflation would indeed be higher (economic agents don't seem to care what the mechanism by which inflation will end up being actually higher), and would spend more (holding to cash would hurt them).

So if the Fed says inflation could go up to 4%, even though oil prices are low, and wages are stagnant, economic agents ignore facts, and hold to the expectations of inflation. In this case, by spending, with the economy being at the natural level, economic agents cause the inflation that the Fed stimulated in a self-fulfilling prophesy. Again, inflation occurs because of excess spending when the economy is at the natural rate. The key to understand how (what mechanism) the Fed can (or can't) affect prices is crucially linked to that very problematic concept of the natural rate.

Don't get me wrong. I think the Fed can affect prices, but is way less effective than what the conventional wisdom suggests, and its powers are asymmetric, meaning it can reduce inflation more than it can increase it. First, hiking the rate of interest, from a cost perspective, increases financial burden of firms and that might lead to higher prices (something that was known as the Gibson Paradox, the positive relation between the interest rate and the price level; later has been also known as the Cavallo-Patman effect). But higher rates, more importantly, increase the burden of debt, leading consumers and firms to possibly default, and reduce the level of activity. It is the lower level of activity, and its impact on workers bargaining power, and, hence, the absence of wage pressures, that matters for stabilization.

On the other hand, reducing rates as noted above might have little impact on spending and the level of activity. Traditionally low rates were instrumental in making fiscal expansion easier, since the government could borrow at low rates. But in the absence of government spending, and any other additional increase in autonomous spending, lower rates per se are unlikely to lead to a booming economy, particularly one that is beyond full capacity and that would display demand-pull inflation (inflation more often than not is cost-push anyway).

* Laurence Ball now says the natural rate of unemployment is around 4.3%, for example.

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