It seems unfortunate that we've given up on Friedman's view that 'inflation' is a monetary phenomenon, as opposed to price increases due to relative changes in supply and demand.
I understand that we don't have a metric that can distinguish between the factors that cause prices to increase. But 'inflation' due to an increase in demand for oil or a war that reduces the supply of wheat is very different from 'inflation' that results from a Federal Reserve that finances major fiscal programs.
The Fed takes account of the "Brownian movement" shocks (economic events) that are constantly happening and targets an amount of inflation that maximally facilitated the relative price movements needed to clear markets, an income maximizing inflation target. This inflation is 100% a monetary phenomenon.
If there are extraordinarily large shocks, the Fed would engineer temporarily over-target inflation. to facilitate the extraordinarily large relative price movements. "Temporarily" implies that it will first raise the rate of inflation over target and then bring it back done when the extraordinary relative price adjustments have been accomplished by this 100% monetary phenomenon.
Yes, a shock from a sudden change in taxing or spending could conceivably push sectoral resource allocations enough to require the Fed to increase inflation, but I'd guess that in most cases the Fed would just raise interest rated to keep to its inflation target. But whatever it did, keep inflation constant or temporarily raise it, it would still be a monetary phenomenon.
Thanks for your comment. It's been a while since I studied economics in graduate school. I was wondering if you could elaborate:
* What does it mean to target an amount of inflation that maximally facilitates the relative price movements to clear markets, an income maximizing inflation target?
*Similarly with extraordinarily large shocks - what does it meant to temporarily over-target inflation to facilitate the extraordinarily large relative price movements?
*As I understand your comments, the fed would 'engineer' a temporary increase in the rate of inflation over target when an increase in oil prices causes a meaningful increase in the CPI. That seems counter-intuitive. Doesn't that increase the CPI even more than the original change in the relative price of oil? How does increasing the rate of inflation change the fact that oil has become relatively more expensive and everyone who consumes oil must either buy less of it or less of something else.
* It seems like a lot of precise 'targeting' from a Fed that 'follows the data' because it does not actually know what outcome its policies will produce.
I'm sure I was in graduate school long before you were. :)
My view is that any large enough shock including a negative supply shock such as an increase in the price of oil means that the economy needs to produce more substitutes for oil and less of other things. To accomplish this, relative prices must change some go up and some go down. If some prices (and not just undifferentiated "wages") are sticky downward, the adjustment will have to come from and increase in the non-sticky prices. This implies that the average of all prices needs to go up. The Fed needs to "engineer/permit" the amount of inflation needed (and no more) to allow the relative price changes. This implies that inflation will rise above target "temporarily" and then be brought back down. And the increase in prices of some non-sticky things will be "transitory."
I describe this as what and omniscient Fed with a perfect disaggregated model of the economy would do. [Corollary: this perfect Fed would always head off recessions = some markets not clearing because relative prices do not adjust enough.] But what else should we shoot for? [Obviously in RL the Fed does NOT know exactly what the up and down trajectory of inflation is optimal OR exactly hot to engineer it if it did.]
Bringing this back to 2020-23 _I_ think the Fed was doing the right thing to goose the economy price level with near zero EFFR and QE purchases up until about September 2021. That is when TIPS started going well over target. And not starting to raise the EFFR until March 2022 was a mistake. Inflation was higher for longer than necessary to effect the changes in relative prices provoked by COVID/Recovery. And _I_ was worried (apparently unnecessarily) that the Fed was correcting its mistake too aggressively. But what does "some guy on the Internet" know? :)
You must have been in graduate school before me - according to your LinkedIn page, you were at the University of Michigan from 1958 to 1971! I was in the graduate program at the University of Minnesota 1974-1976, when I quickly concluded that I had no interest in real analysis or solving quadratic equations.
I was in the class with Lars Hansen (really nice guy as well as super bright) and my professors included Thomas Sargent (macroeconomics), Neil Wallace (monetary policy), Chris Sims (econometrics) and Leo Hurwicz (I'm not even sure what that class was called, but I recall that Hurwicz spent a fair amount of time explaining Arrow's proof in Social Choice and Individual Values). A super high caliber group of colleagues and professors that I was not fit to be part of. (A brief aside, I was a teaching assistant to Walter Heller's Econ 101, but by then Heller was considered to be more of a celebrity than an economist).
Back to the Fed, my view of the Fed is that its tools are mostly blunt instruments that are not capable of doing the fine tuning you ascribe to them. I'm interested in learning more.
For whatever my amateur opinion is worth, I thought the Fed was correct to provide liquidity in 2009-2010, but was mistaken not to raise rates afterwards. Having a zero cost of borrowing for a decade kept the stock market inflated and firms alive that probably should have called it quits. I recall discussing a similar issue during the pandemic with an attorney in Germany who was involved in commercial real estate - it was impossible for his clients to value property when the commercial renters were being kept alive by cost-free borrowing.
I agree that the Fed's tools are blunt, but I think the greater problem is that the Fed cannot well predict how the economy will react to movements in its tools.
I can't agree about post 2010 Fed policy. I think the FEd was not doing enough to maintain inflation and inflation expectations at target. Now in an alternative history in which it had been more aggressive in 2009-10 then afterward a higher EFFR would have been compatible with target inflation.
It seems unfortunate that we've given up on Friedman's view that 'inflation' is a monetary phenomenon, as opposed to price increases due to relative changes in supply and demand.
I understand that we don't have a metric that can distinguish between the factors that cause prices to increase. But 'inflation' due to an increase in demand for oil or a war that reduces the supply of wheat is very different from 'inflation' that results from a Federal Reserve that finances major fiscal programs.
Looking forward to your reply.
"We" have not given up that view.
The Fed takes account of the "Brownian movement" shocks (economic events) that are constantly happening and targets an amount of inflation that maximally facilitated the relative price movements needed to clear markets, an income maximizing inflation target. This inflation is 100% a monetary phenomenon.
If there are extraordinarily large shocks, the Fed would engineer temporarily over-target inflation. to facilitate the extraordinarily large relative price movements. "Temporarily" implies that it will first raise the rate of inflation over target and then bring it back done when the extraordinary relative price adjustments have been accomplished by this 100% monetary phenomenon.
Yes, a shock from a sudden change in taxing or spending could conceivably push sectoral resource allocations enough to require the Fed to increase inflation, but I'd guess that in most cases the Fed would just raise interest rated to keep to its inflation target. But whatever it did, keep inflation constant or temporarily raise it, it would still be a monetary phenomenon.
Thanks for your comment. It's been a while since I studied economics in graduate school. I was wondering if you could elaborate:
* What does it mean to target an amount of inflation that maximally facilitates the relative price movements to clear markets, an income maximizing inflation target?
*Similarly with extraordinarily large shocks - what does it meant to temporarily over-target inflation to facilitate the extraordinarily large relative price movements?
*As I understand your comments, the fed would 'engineer' a temporary increase in the rate of inflation over target when an increase in oil prices causes a meaningful increase in the CPI. That seems counter-intuitive. Doesn't that increase the CPI even more than the original change in the relative price of oil? How does increasing the rate of inflation change the fact that oil has become relatively more expensive and everyone who consumes oil must either buy less of it or less of something else.
* It seems like a lot of precise 'targeting' from a Fed that 'follows the data' because it does not actually know what outcome its policies will produce.
Thanks for your help.
I'm sure I was in graduate school long before you were. :)
My view is that any large enough shock including a negative supply shock such as an increase in the price of oil means that the economy needs to produce more substitutes for oil and less of other things. To accomplish this, relative prices must change some go up and some go down. If some prices (and not just undifferentiated "wages") are sticky downward, the adjustment will have to come from and increase in the non-sticky prices. This implies that the average of all prices needs to go up. The Fed needs to "engineer/permit" the amount of inflation needed (and no more) to allow the relative price changes. This implies that inflation will rise above target "temporarily" and then be brought back down. And the increase in prices of some non-sticky things will be "transitory."
I describe this as what and omniscient Fed with a perfect disaggregated model of the economy would do. [Corollary: this perfect Fed would always head off recessions = some markets not clearing because relative prices do not adjust enough.] But what else should we shoot for? [Obviously in RL the Fed does NOT know exactly what the up and down trajectory of inflation is optimal OR exactly hot to engineer it if it did.]
Bringing this back to 2020-23 _I_ think the Fed was doing the right thing to goose the economy price level with near zero EFFR and QE purchases up until about September 2021. That is when TIPS started going well over target. And not starting to raise the EFFR until March 2022 was a mistake. Inflation was higher for longer than necessary to effect the changes in relative prices provoked by COVID/Recovery. And _I_ was worried (apparently unnecessarily) that the Fed was correcting its mistake too aggressively. But what does "some guy on the Internet" know? :)
Ha ha!
You must have been in graduate school before me - according to your LinkedIn page, you were at the University of Michigan from 1958 to 1971! I was in the graduate program at the University of Minnesota 1974-1976, when I quickly concluded that I had no interest in real analysis or solving quadratic equations.
I was in the class with Lars Hansen (really nice guy as well as super bright) and my professors included Thomas Sargent (macroeconomics), Neil Wallace (monetary policy), Chris Sims (econometrics) and Leo Hurwicz (I'm not even sure what that class was called, but I recall that Hurwicz spent a fair amount of time explaining Arrow's proof in Social Choice and Individual Values). A super high caliber group of colleagues and professors that I was not fit to be part of. (A brief aside, I was a teaching assistant to Walter Heller's Econ 101, but by then Heller was considered to be more of a celebrity than an economist).
Back to the Fed, my view of the Fed is that its tools are mostly blunt instruments that are not capable of doing the fine tuning you ascribe to them. I'm interested in learning more.
For whatever my amateur opinion is worth, I thought the Fed was correct to provide liquidity in 2009-2010, but was mistaken not to raise rates afterwards. Having a zero cost of borrowing for a decade kept the stock market inflated and firms alive that probably should have called it quits. I recall discussing a similar issue during the pandemic with an attorney in Germany who was involved in commercial real estate - it was impossible for his clients to value property when the commercial renters were being kept alive by cost-free borrowing.
I look forward to your columns!
I agree that the Fed's tools are blunt, but I think the greater problem is that the Fed cannot well predict how the economy will react to movements in its tools.
I can't agree about post 2010 Fed policy. I think the FEd was not doing enough to maintain inflation and inflation expectations at target. Now in an alternative history in which it had been more aggressive in 2009-10 then afterward a higher EFFR would have been compatible with target inflation.
Thanks for your comments