Inflation Targeting and Global Supply Shocks

Does the worldwide increase in the price of energy and food present a challenge for inflation targeting? In a Project Syndicate column last week, Joe Stiglitz wrote:

The World’s central bankers are a close-knit club, given to fads and fashions. In the early 1980’s, they fell under the spell of monetarism, a simplistic economic theory promoted by Milton Friedman. After monetarism was discredited – at great cost to those countries that succumbed to it – the quest began for a new mantra. The answer came in the form of “inflation targeting,” which says that whenever price growth exceeds a target level, interest rates should be raised. This crude recipe is based on little economic theory or empirical evidence; there is no reason to expect that regardless of the source of inflation, the best response is to increase interest rates....

That is somewhat unfair - inflation targeting is grounded in economic theory. In particular, it provides a mechanism to improve the credibility of monetary policy in the face of the time-consistency problem (the discovery of which earned a Nobel Prize for Kydland and Prescott). Anyhow... Stiglitz continues:

Today, inflation targeting is being put to the test – and it will almost certainly fail. Developing countries currently face higher rates of inflation not because of poorer macro-management, but because oil and food prices are soaring, and these items represent a much larger share of the average household budget than in rich countries. In China, for example, inflation is approaching 8% or more. In Vietnam, it is even higher and is expected to approach 18.2% this year, and in India it is 5.8%. By contrast, US inflation stands at 3%. Does that mean that these developing countries should raise their interest rates far more than the US?

Inflation in these countries is, for the most part, imported. Raising interest rates won’t have much impact on the international price of grains or fuel...

It should be noted that the countries Stiglitz mentions are not inflation targeters; the practice is more common among high income countries like Australia, Canada, New Zealand and the UK. The issue of how central banks should respond to commodity and energy price shocks applies in rich countries, too (though to a lesser degree because food and energy have less weight in the price indexes of high income countries). Back to Stiglitz:

Raising interest rates can reduce aggregate demand, which can slow the economy and tame increases in prices of some goods and services, especially non-traded goods and services. But, unless taken to an intolerable level, these measures by themselves cannot bring inflation down to the targeted levels. For example, even if global energy and food prices increase at a more moderate rate than now – for example, 20% per year – and get reflected in domestic prices, bringing the overall inflation rate to, say, 3% would require markedly falling prices elsewhere. That would almost surely entail a marked economic slowdown and high unemployment. The cure would be worse than the disease.

So, what should be done? First, politicians, or central bankers, should not be blamed for imported inflation, just as we should not give them credit for low inflation when the global environment is benign. Former US Federal Reserve Chairman Alan Greenspan, it is now recognized, deserves much blame for America’s current economic mess. He is also sometimes given credit for America’s low inflation during his tenure. But the truth is that America in the Greenspan years benefited from a period of declining commodity prices, and from deflation in China, which helped keep prices of manufactured goods in check....

At VoxEU, Axel Leijonhufvud makes a similar argument:

Critical to the central banking doctrine was the proposition that monetary policy is fundamentally only about controlling the price level. Using the bank’s power over nominal values to try to manipulate real variables such as output and employment would have only transitory and on balance undesirable effects. The goal of monetary policy, therefore, could only be to stabilise the price level (or its rate of change). This would be most efficaciously accomplished by inflation targeting, an adaptive strategy that requires the bank to respond to any deviation of the price level from target by moving the interest rate in the opposite direction.

This strategy failed in the United States. The Federal Reserve lowered the federal funds rate drastically in an effort to counter the effects of the dot.com crash. In this, the Fed was successful. But it then maintained the rate at an extremely low level because inflation, measured by various variants of the CPI, stayed low and constant. In an inflation targeting regime this is taken to be feedback confirming that the interest rate is “right”. In the present instance, however, US consumer goods prices were being stabilised by competition from imports and the exchange rate policies of the countries of origin of those imports. American monetary policy was far too easy and led to the build-up of a serious asset price bubble, mainly in real estate, and an associated general deterioration in the quality of credit. The problems we now face are in large part due to this policy failure.

To be clear, the Fed is not an explicit inflation targeter, though it does seem to have an informal "comfort zone" of 1-2% for core inflation (i.e. inflation calculated with food and energy prices removed).

Inflation targeting has generally considered to be a success: it is credited with helping to reduce and stabilize inflation, and anchor inflation expectations in the countries that have adopted it.

The problem now arises of responding to external shocks (although Leijonhuvfud sees a failure in the Fed's past response to positive shocks - of course, there weren't too many complaints at the time...). Accommodating the shock - i.e. allowing the inflation rate to rise above the target level - would damage credibility, but maintaining the target means reducing aggregate demand so that the average price level meets the target - this means lower, or even negative, changes in the prices of other goods.

Supply shocks, a.k.a. "cost push inflation," are not a new dilemma for monetary policy, but this is the most significant instance of this problem since inflation targeting became widespread in the 1990's.

Willem Buiter takes a much different view from Stiglitz and Leijonhufvud. In a Maverecon blog post, he asks "who or what causes inflation?" and answers:

This one is easy. In a fiat money world, central banks cause inflation, or, more precisely, only central banks are resposible for inflation. Other shocks, real and nominal, can influence the general price level if the central bank does not respond swiftly and determinedly, but these non-central bank-induced changes in the general price level can always can be offset by the central bank, given enough time, freedom to act and courage.

So, in the medium and long term (at horizons of two years and over, say) central banks choose the average rate of inflation. Not globalisation; not indirect taxes; not bad harvests; not OPEC and the price of oil; not the Chinese and their exchange rate management. There is no oil inflation, food inflation or cost-push inflation. There is just inflation. Inflation may be accompanied by changes in key relative prices - in the real prices of oil, of food, of oil and of labour for instance - if other relative demand and supply shocks accompany the inflationary impulses created by the central bank. Large increases in the real price of food will be bad news to food importers (including most urban households) and good news to rural food producers and exporters. But don’t confuse it with inflation....

I am willing to grant the old-Keynesians and new-Keynesians among us, the empirical regularity that at very high frequencies, the fact that most nominal commodity prices (and prices of non-core goods in general) are flexible (both ways), while most nominal core goods and services are sticky in the short run. So relative demand or supply shocks that cause the relative price of non-core goods to go up will tend to do so in the first instance through an increase in the nominal price of non-core goods rather than through a reduction in the nominal price of core goods and services; likewise relative demand or supply shocks that cause the relative price of non-core goods to do down will tend to do so in the first instance through a decline in the nominal price of non-core goods rather than through an increase in the nominal price of core goods and services.

So for a given stance of past, current and future monetary policy (as measured by the sequence of past, present and contingent future policy rates), relative demand and supply shocks that cause an increase in the relative price of non-core goods (the kind of shocks we are seeing globally today), will temporarily raise inflation above the level at which it would have been without these relative demand and supply shocks but with aggregate demand and supply at the same level. Such general price level blips work their way through the system quite swiftly; much of it is gone within a year, virtually all of it within two years. They do not ’cause inflation’.

Or, as Milton Friedman famously put it, inflation is always and everywhere a monetary phenomenon.

See also Mark Thoma's comments on Stiglitz and on Leijonhuvfud.

Update (5/15): The FT's Martin Wolf urges Britain to stay on target. He says: "The lesson of the 1970s was simple: letting inflation rip, to avoid pain in the short run, greatly increased pain in the long run. The UK must not repeat that error."

The Economic Consequences of Mr. Bickle?

According to the FT's Alphaville blog, Robert Mundell is claiming that "Taxi Driver" played a crucial role in economic history:

The 1976 classic, directed by Martin Scorsese with Robert De Niro as the bitterly alienated protagonist [Travis Bickle], gave the world De Niro’s catchphrase “You talking to me?,” and also introduced a young Jodie Foster. But what does it have to do with the world economy?

John Hinckley, the deranged would-be assassin who attempted to kill Ronald Reagan in 1981, claimed that he was inspired by it. He said that his action was an attempt to impress Foster. (The movie features a scene in which a mohawked De Niro attempts to assassinate a politician.)

According to Mundell, the wave of sympathy for President Reagan that was engendered by the assassination attempt deterred Democrats in Congress from voting against his proposed tax cuts. Due to this accident of history, the US administered a big fiscal stimulus at the same time that Paul Volcker at the Federal Reserve was administering tight money. This, for Professor Mundell, was vital in creating the era of prosperity that followed.

“Taxi Driver is the most important movie ever made from the standpoint of creating GDP,” Mundell told delegates. “It’s the movie that made the Reagan revolution possible. That movie was indirectly responsible for adding between $5 trillion and $15 trillion of output to the US economy.”

Um... I'm not quite sure what to say about that, but, setting aside my disagreement on the merits of Reagan's economic policies (see, e.g., this earlier post), here are several thoughts:

• It was also very crucial that Hinckley missed - as an opponent in the 1980 Republican primary, Vice President Bush had referred to Reagan's economic proposals as "voodoo economics."
• Reagan did have a complicated relationship with movies, as this story told by former House Speaker Tip O'Neill reminds us:

  When Reagan commented on O'Neill's huge oak desk, the Speaker said it had once belonged to Grover Cleveland. Replied Reagan: "You know, I once played Grover Cleveland in the movies." O'Neill had to correct him: "No, Mr. President. You're thinking of Grover Cleveland Alexander, the ball player."

• Movies are endogenous - the same climate of disaffection that made films like "Taxi Driver" resonate with the public also led to the political shifts that allowed Reagan to be elected.

Black on Stimulus Package

Lewis Black is skeptical about the effectiveness of fiscal policy:

The Economist Rap

I am so un-hip that I was unaware of the existence of "Nerdcore" rap, until Chris Blattman (and Tyler Cowen) pointed me to this hip-hop homage to "The Economist" magazine:

Psikotic – The Economist

Does this mean it is, indeed, hip to be square?

Gas Tax: Clinton Trusts Her Gut (Not Economists)

Hillary Clinton seems to be resorting to the "truthiness" defense of the gas tax holiday proposal. The Times' campaign blog reports:

This morning, George Stephanopoulos began his televised interview with Senator Hillary Rodham Clinton by asking if she could name a single economist who supported her plan for a gas-tax suspension.

Mrs. Clinton did not.“I’m not going to put in my lot with economists,” she said on the ABC program “This Week.” A few moments later, she added, “Elite opinion is always on the side of doing things that really disadvantages the vast majority of Americans.”

Throughout the exchange, Mrs. Clinton argued that she trusted her own eyes and ears instead. “This gas tax issue to me is very real,” she said, “because I have been meeting people across Indiana and North Carolina who drive for a living, who commute long distances, who would save money.”

Senator Barack Obama has derided the gas-tax suspension as a gimmick that would save consumers little and cost thousands of jobs. Kara Glennon, a member of the audience at a town-hall-style meeting, seemed to agree. Gas prices are “not academic” for her, she told Mrs. Clinton, because she makes less than $25,000 a year — and then she accused Mrs. Clinton of pandering. “Call me crazy, but I listen to economists because I think I know what they studied,” she said.

Thank you, Ms. Glennon. The American people may be smarter than Clinton and McCain (who first proposed the idea) give them credit for; Reuters reports:

The poll also found that Americans were divided over one of the hottest issue in the campaign, a gasoline tax suspension. Forty-nine percent think lifting the tax is a bad idea, while 45 percent approve of the plan.

Meanwhile, the economics profession continues to reject and denounce the idea: over 150 economists, including some prominent names, have signed a statement opposing it (for more, see this earlier post).

Update (5/6): Speaking of truthiness, Stephen Colbert applauds Clinton and McCain for their "courage in the face of so-called experts," and urges them to take the gas tax holiday a step further:"Backing a policy experts think is a terrible idea just proves you are ready to be president," he says. Indeed. Here is the web version of the economists' open letter opposing the holiday, which continues to accumulate signatures. At Econbrowser, James Hamilton analyzes the effects of higher gas prices and explains why he signed the letter. Greg Mankiw finds that the proposal has an unsurprising origin.

Update #2 (5/6): Krugman says we're overreacting.
Update #3 (5/7): No, we're not, say Mankiw, and deLong, who believes "it is important that presidential candidates fear economists."

Inflation Under a Microscope

Check out this nifty interactive graphic from the Times decomposing the year's increase in the Consumer Price Index into its component parts. It vaguely reminds me of something one might see in a under a microscope in science class, or maybe a stained-glass window...

In Defense of Bernanke

Macroeconomists often act as Monday-morning quarterbacks of monetary policy, and Ben Bernanke has gotten plenty of criticism, some of it rather harsh. Taking a more favorable view, in Barron's, Randall Forsyth defends Bernanke's handling of the credit crisis:

Importantly, these innovations [the TSLF and PDCF*] obviate the need for the Fed, in the widely cited words of a speech by Bernanke in 2003, to drop dollars from helicopters to stave off a deflationary crisis. The present Fed chairman gets credit (and blame) for that turn of phrase, but it originated with Nobel Laureate Milton Friedman.

Indeed, much of Bernanke's academic work built on the insights of Friedman and his collaborator, Anna J. Schwartz, who pinned the blame of the Great Depression on the Fed for permitting the money supply to contract by one-third. Bernanke's work focused on how that happened; the answer was basically a breakdown in the financial system.

Using that insight, Bernanke has fashioned these new instruments to make sure the 21st century financial system does not break down as the one of the 1930s did. Until now, the instruments were extremely blunt -- as in driving short-term rates down to 1% under his predecessor, Alan Greenspan, and holding them at preternaturally low levels even after the economy and the financial system recovered from the tech-telecom bust.

In essence, Ben Bernanke has come up with an alternative to the monetary printing press to deal with the greatest credit bubble and bust in history...

Hat tip to The Big Picture.
*The Primary Dealer Credit Facility (opening discount window lending to investment banks) and Term Securities Lending Facility (loans of Treasury securities collateralized by mortgage backed securities; see this earlier post). Also, Real Time Economics has a brief guide to the "alphabet soup."

Update (5/4): Paul Krugman writes:

The Fed’s efforts these past nine months remind me of the old TV series “MacGyver,” whose ingenious hero would always get out of difficult situations by assembling clever devices out of household objects and duct tape.

Now that is high praise, indeed!

0.6 + 5.0 + 2.0 = recession-ish

The BEA's advance estimate of real GDP reported growth at an annual rate of 0.6% - slow, but positive - for the first quarter of 2008 (the same rate as the last quarter of 2007). Consumption contributed positively (growth in services consumption outweighed a decline in goods consumption), as did government purchases (especially federal defense expenditures) and net exports (partly thanks to the weak dollar). Declining investment - particularly residential (i.e. new housing, down 26.7%!) was a drag. Inventory accumulation made a large positive contribution, which is somewhat worrisome because it suggests firms are piling up unsold goods and therefore might reduce output in the future. However, it should be noted that inventories were falling in the fourth quarter of '07, so the increase might partly reflect a return to normal stocks.

Since output is not falling, this would not meet the NBER's definition of a recession. However, by a useful rule of thumb - Okun's law - the economy needs to grow around 3% to keep unemployment from rising (because the labor force is growing and productivity growth increases the amount of output each worker can produce). So while economics professors who are being careful in their choice of words won't call it a "recession" we are in what Brad deLong is calling a "recession-like episode" and, as Paul Krugman puts it:

...[T]he official definition of recession has become delinked from peoples’ actual experience. Right now, we’re in an economy with deteriorating employment and incomes, collapsing home prices, and business retrenchment. Is it also an economy in recession? Who cares?

This Tom Toles cartoon makes a similar point. And, of course, the GDP numbers are subject to revision, as Menzie Chinn notes.

About that deteriorating employment.... the April report from the BLS reported a decline in the unemployment rate from 5.1% to 5.0% (which suggests a GDP growth rate >3% in April), and, in this case it is not an artifact of discouraged workers leaving the labor force. In the household survey, the number of people employed increased by 360,000, the number unemployed decreased by 189,000 while labor force participation was basically unchanged (increasing from 66.00% to 66.02%). The establishment survey reported a decline in "nonfarm payroll employment" of 20,000; the result of a decrease of 110,000 jobs in goods producing sectors and an increase of 90,000 in service employment. Not as bad as expected, but the overall picture is still un-good, according to the Times:

Companies are cutting working hours, even as many avoid layoffs. Those working part time because of slack business or out of failure to find full-time work swelled from to 5.2 million in April from 4.9 million in March. In percentage terms, employees working part time involuntarily climbed to the highest level since 1995.

The average weekly pay for rank-and-file workers — about 80 percent of the American work force — fell $3.55 in April, to $602.56 in inflation-adjusted terms. This figure has been generally falling since the end of 2006. Gains in pay have been canceled out by the soaring costs of food and energy.

“The punch line is that you don’t have to lose your job to get pinched in a recession,” said Jared Bernstein, senior economist at the labor-oriented Economic Policy Institute in Washington. “Understandably we focus on layoffs and job losses, but most people keep their jobs in a recession. People who held their jobs are losing ground both in terms of hours and hourly wages.”

The Fed, though, may be done helping for now. On Wednesday, they announced a reduction in the Federal Funds rate target of 0.25% to 2.0%. Their statement hinted that we may have reached the end of the easing cycle (which began last September when the rate target was cut from 5.25% to 4.75%):

The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

Since monetary policy affects the real economy with a lag, there should be a boost in the pipeline for this summer and fall, and the Fed may need to turn its attention to shoring up its anti-inflation credibility. Or, in the statement's Fed speak:

Although readings on core inflation have improved somewhat, energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook remains high. It will be necessary to continue to monitor inflation developments carefully.

The Presidents of the Dallas and Philadelphia Feds, Richard Fisher and Charles Plosser, voted against cutting for the second consecutive time, apparently thinking the Fed has gone too far already. That also seems to be what Allan Meltzer thinks, according to the Times: “My view is that the Fed is back doing the silly things it did in the 1970s, of trying to make judgments that have long-term consequences based on short-term data.” The futures markets expect the Fed to hold the line at 2.0% at the June meeting.

Gas Tax Pander Bears

Hillary Clinton is following John McCain's lead again, the Times reports:

Senator Hillary Rodham Clinton lined up with Senator John McCain, the presumptive Republican nominee for president, in endorsing a plan to suspend the federal excise tax on gasoline, 18.4 cents a gallon, for the summer travel season. But Senator Barack Obama, Mrs. Clinton’s Democratic rival, spoke out firmly against the proposal, saying it would save consumers little and do nothing to curtail oil consumption and imports.

Politically, it seems like an odd moment for Obama to eschew a cheap pander (somewhere, Paul Tsongas is smiling), but on the substance he is right, as Dean Baker explains:

Actually, almost all economists would agree that the tax cut proposed by Senators Clinton and McCain would save consumers nothing. With the supply of gas largely fixed by the capacity of the oil industry (they claim to be running their refineries at full capacity), the price will not change in response to the elimination of the tax. The only difference will be that money that used to go to the government in tax revenues will instead go to the oil industry as higher profits.

As Baker notes, the public is ill-served by coverage that fails to make clear the impact (or lack thereof) of this proposal.

The Tax Policy Center's Len Burman and Eric Toder are also critical. They write "unless the plan's aim is to boost short-term profits for petroleum refineries, the proposal makes no sense."

Update: More from the Washington Post's Fact Checker, Thomas Friedman, Howard Gleckman and Paul Krugman (who seems to have a hard time saying anything positive about Obama).

Update #2 (5/2): Apparently I'm not the only one having a Paul Tsongas flashback. Meanwhile, Clinton campaign official Howard Wolfson says: “There are times that a president will take a position that a broad support of quote-unquote experts agree with. And there are times they will take a position that quote-unquote experts do not agree with.” Ugh.

Ex-Fiscal Conservatives

In the Times, David Leonhardt profiles McCain economics advisor Douglas Holtz-Eakin. Although the tone is sympathetic, Leonhardt cannot avoid asking the awkward question "are there any fiscal conservatives anymore?"

Holtz-Eakin headed the Congressional Budget Office when it took a stab at "dynamic scoring." Though that sounds like something Billy Dee Williams might do, it actually means trying to incorporate "supply side" effects into estimates ("scoring") of the revenue losses associated with tax cuts. Leonhardt writes:

When Douglas Holtz-Eakin took over in 2003 as the director of the Congressional Budget Office — the nation’s bean counter in chief — he walked right into a firestorm.

For years, Republicans had been pushing the budget office to change the way it estimated the cost of a tax cut. Rather than looking only at the revenue lost, they argued, the office should also consider how tax cuts would change behavior. With lower tax rates, businesses would invest more, workers would work more — and the government would thus get a tax windfall. This, in a nutshell, is supply-side economics.

A bearded academic, Mr. Holtz-Eakin had just finished a stint in the Bush administration and had spoken favorably about dynamic analysis. So his appointment excited Republicans almost as much as it scared Democrats. Senator Kent Conrad went so far as to call it “a mistake.”

But it turns out that both parties underestimated Mr. Holtz-Eakin. He did indeed begin using dynamic analysis, which makes a lot of sense, since tax rates really do alter people’s behavior. Yet he used it as it should be used.

What the budget office found, as study after study has shown, was that any new revenue that tax cuts brought in paled in comparison with their cost....

Now Holtz-Eakin is working for a candidate who opposed the 2001 and 2003 Bush tax cuts, but now wants to extend them, and go further. McCain's vague promises of spending cuts to keep the deficit under control are reminiscent of David Stockman's "magic asterisk." Leonhardt:

To deal with the deficit, Mr. McCain has said that he will get tough on year-to-year spending, both in military programs and domestic ones. Then he will try to remake Medicare and Medicaid so that, as Mr. Holtz-Eakin puts it, they no longer pay doctors “based on what they do to people, instead of what they do to make people well.” It’s a fine idea.

The problem is that the campaign has been far, far more detailed about its tax cuts, which would worsen the deficit, than its spending cuts, which would reduce it. Mr. McCain has proposed the elimination of the alternative minimum tax (at a cost of $60 billion a year), new child tax deductions ($65 billion), a corporate tax cut ($100 billion) and faster write-offs for corporate investments in new equipment ($50 billion to $75 billion).

Of course, there are some who are in denial about the budgetary consequences of a tax cut, still peddling the claim that somehow revenues will rise - and one of those cranks, Arthur Laffer, is also advising McCain (as is Kevin Hassett, co-author of "Dow 36,000;" see Jeff Frankel's comments). Given the varied quality of his advisors, and his flip-flops on the issues, what McCain really thinks - and really would do in office - is anyone's guess. Washington Post columnist Ruth Marcus believes we're not getting straight talk:

Call it McCainsian Economics. Its seminal treatise: "The General Theory of Getting Elected."

In the space of just a few years, McCain has morphed from someone who worried about the cost of the Bush tax cuts into a rabid tax-cutter. You don't need a fancy equation to explain this turnabout. McCain is running for president at the helm of a party that's deathly allergic to taxes and highly suspicious of him on this score. His campaign-trail buddy is Phil Gramm, the former Texas senator. When it comes to fiscal responsibility versus more tax cuts, Gramm is what your mother would call a bad influence.

McCain 2001 said he could not "in good conscience support a tax cut in which so many of the benefits go to the most fortunate among us, at the expense of middle-class Americans." McCain 2008 pushes a tax policy that makes Bush's plan look like a soak-the-rich scheme....

Although some respectable economists do believe that tax cuts can alter incentives and induce additional labor supply and capital accumulation, the notion that those effects would be large enough to increase revenues is well known to be fantasy. For example, this analysis by Greg Mankiw, a Republican and former Bush advisor, and Matthew Weinzerl used a neoclassical growth model to find that, in the long run, the supply side effects reduce the revenue impact of capital and labor taxes by 50% and 16.7%, respectively (that's after a transition to a new steady state; the effects are much smaller at, say, a 10-year horizon). What their analysis appears to leave out is the impact of deficit spending, which reduces capital accumulation through the "crowding out" effect (i.e. the government borrows some of the saving that otherwise would have financed investment).

This Jeff Madrick column from 2003 has more on the CBO study of the dynamic effects of tax cuts, and is also a nice example of the way in which macroeconomists use a grab-bag of different types of models.

Mark Thoma comments on Leonhardt's story, as does The Economist's Free Exchange.

Update (4/26): Krugman says "it’s really sad to see Holtz-Eakin lending his reputation to this sort of thing."