But as a share of GDP it is a relatively small one:
(that is the share of GDP in the year the war costs peaked)Why care about headline inflation versus core inflation? Simply put, a sustained move of headline inflation to the levels of the 1970s is unlikely without an accompanying increase in the core component. The reason is simple: although they can be highly persistent, rapid increases in the relative prices of energy and food cannot go on indefinitely. Once this process dies down, as long as core inflation remains anchored, headline inflation must converge to it.One criticism of using a core measure is that higher overall (or "headline") inflation feeds into inflationary expectations, which, in turn, influence wage and price setting behavior. Gertler addressed this issue:
Could it be that high headline inflation is unmooring inflation expectations, leading us back to the 1970s through this painful route? Some measures of inflation expectations are edging upwards. This needs to be taken seriously. However, where we should expect the impact of increasing expectations to show up is exactly in the behaviour of core prices and wages.So far this is not happening. Not only has core inflation remained stable but the growth in nominal unit labour costs, on which most pricing of core items is based, also remains benign. It may very well be that the Fed’s reputation for keeping core inflation stable has kept the expectations relevant for price- and wage-setting in line. Also relevant is that, at least to date, wage- setters appear to understand that, however unfortunate, the relative increase in energy and food prices is something beyond the central bank’s control that they must live with.
Fed governor Frederic Mishkin (also a Bernanke co-author), who is leaving for Columbia University, seems a little more concerned about the expectations issue. In his last speech as a Fed official, Mishkin argued that explicit inflation targets - such as that of the European Central Bank - help stabilize, or "anchor" expectations:
[T]here is substantially greater disagreement in long-run inflation forecasts for the United States than for the euro area. As shown in figure 2, the standard deviation of U.S. inflation forecasts at each survey date is higher than the standard deviation of corresponding euro area inflation forecasts. Moreover, the degree of dispersion in the views of individual forecasters has gradually declined towards negligible levels for the euro area but not for the United States. One obvious interpretation of these patterns is that professional forecasters in the United States are less certain about the Federal Reserve's longer-term inflation goal.
That uncertainty may also explain differences in the behavior of inflation compensation as implied by the gap between nominal and real yields on long-term bonds. Figure 3 depicts far-forward inflation compensation (that is, the one-year-forward rate nine years ahead) for the United States and the euro area. Inflation compensation, sometimes referred to as "breakeven inflation," reflects not only inflation expectations but also a premium that compensates for uncertainty about inflation outcomes at the specified horizon. Evidently, far-forward inflation compensation for the euro area displays much smaller fluctuations than for the United States, consistent with greater stability of inflation expectations and a lower degree of uncertainty about longer-run inflation outcomes. Moreover, regression analysis confirms that U.S. far-ahead forward inflation compensation exhibits statistically significant responses to surprises in macroeconomic data releases--consistent with the view that market participants are continuously revising their views about the longer-run outlook for U.S. inflation. In contrast, euro-area inflation compensation does not respond significantly to economic news.
Mishkin goes on to suggest that inflation targeting does not result in worse performance in terms of stabilizing output:
One concern might be that these benefits in anchoring inflation expectations could come at the expense of the performance of output growth. However, the empirical evidence suggests that central banks with explicit inflation goals do not have worse output performances than central banks, such as the Federal Reserve, that have not specified an explicit numerical goal for inflation.So far, this is true, but inflation targeting is relatively new, so I think it is too soon to tell (perhaps a good research topic a few years from now...).
In light of these considerations, I would like to suggest several specific modifications to the Federal Reserve's current communication strategy.If the deviations between core and non-core inflation induced by oil price fluctuations, etc., are indeed transitory (i.e. they die out in a shorter time period than the forecast horizon) there is no tension between tolerating headline inflation spikes in the short run and stabilizing it in the long run. However, a commitment to "long run" inflation targeting which allows substantial "short run" deviations seems rather squishy, and I wonder if it really would earn the Fed the additional credibility that true inflation targeters have.
- First, the horizon for the projections on output growth, unemployment, and inflation should be lengthened. This change might involve simply an announcement of FOMC participants' assessment of where inflation, output growth, and unemployment would converge under appropriate monetary policy in the long run. Alternatively, the horizon for the projections could be extended out further, say to five or more years.
- Second, FOMC participants should work toward reaching a consensus on the specific numerical value of the mandate-consistent inflation rate, and this consensus value should be reflected in their longer-run projections for inflation.
- Third, the FOMC should emphasize its intention that this consensus value of the mandate-consistent inflation rate would only be modified for sound economic reasons, such as substantial improvements in the measurement of inflation or marked changes in the structure of the economy.
From Mexico to India to China, governments fearful of inflation and street protests are heavily subsidizing energy prices, particularly for diesel fuel. But the subsidies — estimated at $40 billion this year in China alone — are also removing much of the incentive to conserve fuel.The oil company BP, known for thorough statistical analysis of energy markets, estimates that countries with subsidies accounted for 96 percent of the world’s increase in oil use last year — growth that has helped drive prices to record levels.
The subsidies prevent the price mechanism from working in a significant part of what is a global market, therefore the adjustments of price and quantity demanded must be larger elsewhere.
I would suspect that policymakers in these countries realize these subsidies are bad policies - indeed, the article describes how many countries are raising prices, but their price increases are falling short of the increase in world prices, so the costs to the governments are nonetheless increasing, even as citizens protest higher prices.
Our results imply that regionalism is a building bloc to free trade. There is no clear evidence that trade preferences lead to higher tariffs or smaller tariff cuts. There is strong evidence that preferences induce a faster decline in external tariffs in free trade areas. For example, if a country that follows a strict policy of non-discrimination offers free access to another country in a sector where it applies a 15% multilateral tariff, the country would tend to subsequently reduce that external tariff by over 3 percentage points. This complementarity effect is stronger in sectors where trade bloc partners are more important suppliers, precisely where trade discrimination would be more disrupting.
In the “very long run”, the real exchange rate (the relative price of the same basket of goods across two countries) is expected to come back to a constant level, due to the convergence of the prices of both traded goods (due to international arbitrage) and non-traded goods (due to productivity equalisation all over the world). In the jargon, this is called purchasing power parity, and it acts as a very long run attractor.They believe this implies "in the long and very-long run, the equilibrium value of the euro [currently $1.57] is found much lower – around 1.10. Thus, our work suggests that the euro may have peaked and be due to fall."
But so far--look: In the dot-com boom of the 1990s we were the winners. The rich investors of America built out a huge amount of fiber-optic cables and conducted an enormous amount of experimentation in business models from which we all benefit. In the real-estate boom of 2000s the rich investors of America and the world built an extra four million houses and loaned the rest of us money at remarkably low interest rates for five years. Those who moved into newly-built houses with teaser-rate mortgages wish those teaser rates would continue--but they won't, and in the meantime they got to live in a nice house for quite a low rent. Those of us who took out big home equity loans wish the low interest rates would continue--but they won't. And those of us who felt rich because our house values have appreciated wish we still could think of ourselves as sleeping on a pile of gold--but we can't.The dot-com bubble and the real-estate bubble were bad news for the investors in Webvan, WorldCom, Countrywide, FNMA, and securitized subprime mortgages. But they were, by and large, good news for the rest of us. And investors are supposed to take care of themselves.
Now we are not yet out of the woods. If the tide of financial distress sweeps the Fed and the Treasury away--if we find ourselves in a financial-meltdown world where unemployment or inflation kisses 10%--then I will unhappily concede, and say that Greenspanism was a mistake. But so far the real economy in which people make stuff and other people buy it has been remarkably well insulated from panic at 57th and Park and on Canary Wharf.
Or, as Keynes said (General Theory, ch. 22):
Thus the remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.See also, more recently, The Onion.
At the risk of sounding Gramm-esque, it is worth bearing in mind that the main macro aggregates - GDP growth, unemployment and inflation - still aren't looking too bad by historical standards....
The index for energy rose sharply for the second straight month, increasing 6.6 percent in June following a 4.4 percent increase in May. The increase in the energy index accounted for around two-thirds of the overall increase in the all items index in June.Core inflation still looks rather more tolerable:
The staff's projection for price inflation in core personal consumption expenditures (PCE) for 2008 as a whole was unchanged; recent readings on core PCE inflation were better than anticipated and led the staff to lower its projection for the first half of the year. But some of the recent improvement was seen as reflecting transitory factors, and the forecast of core inflation for the second half of this year and next year was marked up to incorporate the likely pass-through of the recent jumps in the prices of energy and other commodities, and the reversal of these transitory factors. The further large increase in energy prices also prompted an upward revision of the forecast of headline PCE inflation in the second half of 2008, and headline inflation was expected to exceed core inflation by a considerable margin this year. However, in view of a projected leveling-out of energy prices and the anticipated slack in resource utilization, headline inflation was expected to decline considerably in 2009 from its pace in the second half of 2008, and core inflation was forecasted to edge lower.The projections of the board members and regional presidents appear to be consistent with this.
This is your time, guys & gals. This is why central banks were made operationally independent. If you don’t use the political space created by the laws that granted you operational independence to keep the lid on inflation when this is difficult - as it is today - there is no point in granting central banks operational independence. Only determined action by central banks can put the inflation genie back in the bottle. Praying for a miracle won’t do.
More than 100 professors signed the petition, declaring that they were “disturbed by the ideological and disciplinary preference implied by the university’s massive support for the economic and political doctrines that have extended from Friedman’s work,” and the implication that Chicago’s faculty “lacks intellectual and ideological diversity.”Outside the economics profession, Friedman is probably best known for his evangelism on behalf of free market ideology, so it is understandable why some might raise objections. To which professional economists - especially those of us who do not share Friedman's opinions - should respond: "yes, but... Milton Friedman really was a great economist who made some very important contributions that left a lasting impact and helped shape our understanding of how the economy works."
Milton Friedman played three roles in the intellectual life of the twentieth century. There was Friedman the economist's economist, who wrote technical, more or less apolitical analyses of consumer behavior and inflation. There was Friedman the policy entrepreneur, who spent decades campaigning on behalf of the policy known as monetarism—finally seeing the Federal Reserve and the Bank of England adopt his doctrine at the end of the 1970s, only to abandon it as unworkable a few years later. Finally, there was Friedman the ideologue, the great popularizer of free-market doctrine.Did the same man play all these roles? Yes and no. All three roles were informed by Friedman's faith in the classical verities of free-market economics. Moreover, Friedman's effectiveness as a popularizer and propagandist rested in part on his well-deserved reputation as a profound economic theorist. But there's an important difference between the rigor of his work as a professional economist and the looser, sometimes questionable logic of his pronouncements as a public intellectual. While Friedman's theoretical work is universally admired by professional economists, there's much more ambivalence about his policy pronouncements and especially his popularizing. And it must be said that there were some serious questions about his intellectual honesty when he was speaking to the mass public.
Krugman explains the significance of Friedman's most enduring intellectual contributions on consumption theory and the relationship (or lack thereof) between inflation and unemployment. He is more critical on Friedman's "monetarist" doctrine that monetary policy should be on autopilot, following a rule of growing the money supply at a constant rate. The "questions about his intellectual honesty" come from Friedman's explanations of the Great Depression. There is little doubt that the Federal Reserve failed to act properly, but Krugman argues that Friedman was misleading in suggesting that the Fed caused the depression.
In the conclusion he wrote:
In the long run, great men are remembered for their strengths, not their weaknesses, and Milton Friedman was a very great man indeed—a man of intellectual courage who was one of the most important economic thinkers of all time, and possibly the most brilliant communicator of economic ideas to the general public that ever lived. But there's a good case for arguing that Friedmanism, in the end, went too far, both as a doctrine and in its practical applications.Krugman made some sharp criticisms, but the essay is far from a hatchet job, and the appreciation for Friedman's brilliance and his contributions to economic theory is clearly genuine. Or so I thought...
Edward Nelson and Anna Schwartz apparently didn't think so, offering a letter to the editor criticizing Krugman's essay. The word limit of the NYRB's letters section evidently was too tight a constraint on their anger at Krugman, so they wrote a longer piece "The Impact of Milton Friedman on Modern Monetary Economics: Setting the Record Straight on Paul Krugman's 'Who Was Milton Friedman?'" I was taken aback by this when I first saw it, and quite surprised to see it again in the latest Journal of Monetary Economics, the top academic journal focused on macroeconomics (it is also posted here, if you don't have access to the JME).
Nelson and Schwartz write:To some readers, Krugman's willingness to praise Friedman despite these accusations might indicate that his essay is balanced; but to us, it shows the degree to which the essay consists of doubletalk. Krugman's accusations constitute such fundamental criticisms that, if accurate, they should be sufficient to rule out a favourable conclusion about Friedman. Specifically: How can he say Friedman was a great economist and a great man, if he believes Friedman to have been intellectually dishonest? Or that Friedman was a man of courage, if he misled people?So one must come to a "favorable" or "unfavorable" conclusion about Friedman - be a friend or an enemy - and any opinions that are nuanced, mixed or ambivalent can only be "doubletalk"?
Paul Krugman is a respected trade theorist. But he does not speak authoritatively on subjects on which he has no expertise. Monetary economics is not his field of expertise. Krugman's research background does not qualify him as an authority on Milton Friedman's work. Krugman's scholarly publications rarely mentioned Friedman and, when they did, they acknowledged the contributions of Friedman and monetarism in a way that contradicts his essay on Friedman. Friedman's reputation is intact despite Krugman's deplorable efforts to denigrate him and his contributions.The JME published a short response by Krugman. I suspect what he was really thinking was: "jeez." But that - even for academic bigwigs like Krugman - won't get published in the JME. Instead, Krugman briefly addressed some of the points about the depression and about monetarism before concluding:
Professional economists rarely have a critical word for Milton Friedman's legacy. The current exchange explains why: Friedman's defenders make life very unpleasant for anyone who points out the great man's failings...The tone of Nelson and Schwartz's essay reflects, I think, an earlier era - well before my time - when macroeconomics was much more intensely political. In his short intellectual history, "The Macroeconomist as Scientist and Engineer," Greg Mankiw discusses some of the arguments of the 1970's and 1980's. Writing of an exchange between Robert Solow and Robert Lucas, Mankiw said: "Such vitriol among intellectual giants attracts attention, much in the way that the patrons in a bar gather around a fistfight, egging on the participants. But it was not healthy for the field of macroeconomics." Fortunately, "as the older generation of protagonists has retired or neared retirement, it has been replaced by a younger generation of macroeconomists who have adopted a culture of greater civility."
Its a tribute to the importance of Friedman's work that questions about his legacy bear so directly on contemporary policy issues. But for that reason it's also important not to engage in hagiography. Friedman was a great economist, but like every other great economist in history, he was also wrong about some important things.
