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Inflation and the Fed

taylor1109.png

In general, the Fed's behavior tends to track the Taylor Rule, which is an economic formula based off a mixture of unemployment and inflation. Don't worry, there's not going to be a quiz. Suffice to say that the situation remains bad enough, and strange enough, that the Taylor Rule implies the Fed's interest rates should actually be negative, which would mean they'd be paying people to borrow money. They can't do that, of course, so the incredibly low rates they're offering are actually far, far too high.

That's the context for the debate over whether the Fed should fear inflation, and begin to "tighten" its policy (which would largely mean raising interest rates). What the Fed needs to do, and what everyone knows the Fed needs to do, is further lower rates. But it can't, at least not without resorting to unorthodox measures that, as Brad DeLong says, it regards "with horror, shock, and shame."

At some point, however, the Fed going to need to raise rates. It's going to need to decide when reflation has given way to inflation. And that's what the argument over inflation is actually about. Not whether we're there now, but whether we can trust the Fed to know when we've gotten there, or whether it's going to be listening to the wrong people along the way.

The folks arguing that the Fed needs room to tighten believe that the main pressure on the Fed comes from Congress and the White House, and that the main pressure on Congress and the White House comes from polls showing people are unhappy about the economy, which will mean that the Fed should keep trying to stimulate growth even at the risk of some inflation. But Fed policy works on a lag, and the Fed needs to prepare itself to act long before the political system is ready. Some of these folks also believe that the Fed acting will stimulate investment, as it will mean the Fed believes the recovery is working, and it signals that interest rates won't be lower next year than they are this year, so you'd better invest while the investin' is good.

The folks arguing that the Fed needs to stop worrying about tightening are concerned that elites are weirdly obsessed with, and afraid of, inflation, and the Federal Reserve has historically considered itself an inflation-fighter before anything else. There's something of a structural bias there, and it could lead the Fed to pull the trigger too quickly. If anything, the Federal Reserve needs to get into the quantitative easing business for awhile, as it needs to recognize that unemployment is as big a problem as inflation has ever been, and needs to be battled as creatively and proactively.

I'm with the quantitative easers, but it's also worth saying that the Federal Reserve isn't showing any signs of worrying about inflation. From Ben Bernanke's speech last week (italics mine):

The outlook for inflation is also subject to a number of crosscurrents. Many factors affect inflation, including slack in resource utilization, inflation expectations, exchange rates, and the prices of oil and other commodities. Although resource slack cannot be measured precisely, it certainly is high, and it is showing through to underlying wage and price trends. Longer-run inflation expectations are stable, having responded relatively little either to downward or upward pressures on inflation; expectations can be early warnings of actual inflation, however, and must be monitored carefully. Commodities prices have risen lately, likely reflecting the pickup in global economic activity, especially in resource-intensive emerging market economies, and the recent depreciation of the dollar. On net, notwithstanding significant crosscurrents, inflation seems likely to remain subdued for some time.

The actual debate over whether the Federal Reserve should worry about inflation is still a couple of years away, and Bernanke knows that. The debate worth having right now is whether they should start doing some truly unorthodox things to fight unemployment.

By Ezra Klein  |  November 20, 2009; 2:35 PM ET
Categories:  Federal Reserve  
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Comments

This is the idea in Bartlett's new book--inflationary fears are premature right now because we are actually trying to accomplish reflation, meaning that we are trying to get back to where we were pre-crash. That looks superficially like inflation, but it isn't the same thing. Once we get back to growing, worrying about inflation may be the correct move, but taking action to prevent reflation now inhibits the recovery.

Posted by: StokeyWan | November 20, 2009 3:07 PM | Report abuse

"...the Taylor Rule implies the Fed's interest rates should actually be negative, which would mean they'd be paying people to borrow money. They can't do that, of course, so the incredibly low rates they're offering are actually far, far too high."

Actually, they could have negative interest rates. It would require restructuring the way that currency works. Willem Buiter has a couple of articles on different ways to do this:
http://blogs.ft.com/maverecon/2009/05/negative-interest-rates-when-are-they-coming-to-a-central-bank-near-you/
http://blogs.ft.com/maverecon/2009/05/the-wonderful-world-of-negative-nominal-interest-rates-again/

I'm surprised that haven't seen a lot of discussion of this; it seems like it could work and wouldn't be that difficult to implement if the right people got on board.

Posted by: adamguetz | November 20, 2009 3:55 PM | Report abuse

Two points.

I don't think you understand what truly unorthodox monetary policy is being discussed. You contrast such policy with future policy on inflation in a year or two. The truly unorthodox policy is to promise not to fight inflation in a year or two. The two issues which you contrast are exactly identical. To repeat the unorthodox policy would be for the Fed to say that it won't fight inflation when it starts increasing until it reaches 3%. Check with DeLong and Krugman. You will find their discussions are always about current declarations about monetary policy in the medium term future.

Second, it is fairly clear that elites are strangely obsessed with inflation, because the general public is. Back when the US had moderate inflation (say 12%) pluralities in polls said that was the worst problem the US faced.

Economists tend to agree that this is a totally crazy view and based on the idea that with 0 inflation wages will keep on going up and this won't hurt employment -- so less inflation means higher real wage growth with no costs. I think it is very clear that, on this one, the elite is rationally forecasting irrational public anger about inflation.

Posted by: rjw88 | November 21, 2009 5:28 AM | Report abuse

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