Thursday, October 8, 2009

The Amazing Resilience of the Fed's Inflation-Fighting Credibility

I was looking at the Philadelphia Federal Reserve Bank's Survey of Professional Forecasters and found the CPI inflation forecasts tell some interesting stories. Below is a plot of the 1-year forecast and the 10-year average inflation forecast (click on figure to enlarge):

Unfortunately, the 10-year forecast data only goes back to 1991, but based on the similarities in the two forecasted series we can infer the 10-year forecast was probably elevated in the early 1980s as well. Not a terribly surprising result given the upward-trending inflation experience of the 1960s and 1970s.

What is surprising to me is that relative to where it is today, the Fed's inflation-fighting credibility was still being earned as late as 1998. I was under the impression that Paul Volker came in and with one fell swoop earned the Fed the inflation-fighting credibility that it has today. The figure above suggests it was more of journey with inflation-fighting credibility being gradually earned over the next 17 years or so.

What is even more amazing to me is that the Fed's inflation-fighting credibility has not been harmed by recent developments. The forecasters continue to predict a stable long-term trend inflation rate of 2.5%, roughly the same value that it has been since 1998. Given all the talk about the Fed blowing up its balance sheet and the potential of monetizing the debt this result is nothing less than amazing. It should also give pause to those inflation hawks who only see trouble on the horizon.

8 comments:

  1. They may still have credibility but have we ever experienced such a growth in the base? I am skeptical as to whether they can effectively "exit" the market. OF course, only time will tell.

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  2. You give far too much credit to the Federal Reserve.
    Yes we all know how much central bankers love to pat themselves on the back - after all they gave us the miracle of the Great Moderation, except that they didnt. Arguably the inflation decline - which is not confined to the US but also seen in Europe - was more due to the decimation of union-dominated industries which were an engine of wage cost-push inflation that central banks validated. These industries shift to Asia, giving us low-cost imports that helped to reduce goods market inflation. But as we know asset price inflation continued rampantly, courtesy of the Federal Reserve.

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  3. So how do you think these slow-changing expectations relate to your VAR post showing that inflation expectations don't react with long and variable lags to monetary shocks? If we accepted that monetary policy shocks of the early 1980s took years to fully seep into inflation expectations per your post, couldn't that be as much of a concern for the hawkish as a comfort? Yes, resilience might mean that the Fed could better weather a less than elegant attempt to counter decreasing money demand and the resultant conversion of excess reserves into standard money without repercussions, but it might also mean that if the Fed does lose its grip in the process then both the expecations lag and the nominal spending lags might be long, variable and difficult to correct under a regime that isn't much different than the 1980-2008 regime.

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  4. dlr:

    The VARs were estimated with the 1-year inflation forecast which does have some variation. Nominal spending was responding to this variation not the 10-year forecast.

    Your point on the sluggish updating of long-term inflation expectations and the potential danger associated with it for the Fed is a good one. If the inflation expectation genie gets out of the bottle it could take a long-time to earn back inflation-fighting credibility.

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  5. Because of lagged changes in expectations, some have traditionally looked for leading indicators of those changes: essentially gold, currencies and commodities (in that order). Yet, somehow this idea has fallen into disrepute.

    Why isn't the Fed and the broad consensus of economists looking at price signals? Probably because the commodities inflation of the 2000's never produced follow-on core inflation. If it didn't happen then, why would it happen in 2010-2012 with a yawning output gap?

    So I think the question to ask is: what could change that would produce follow-on core inflation following a strong rise in commodity prices, even in the presence of an output gap? The answer is tautological: if a falling dollar and rising gold were to finally change expectations, then velocity would rise and core inflation would follow. The Fed seems to believe that such an "unanchoring" is a linear process, where they have plenty of time to react, again, in a linear fashion. This is perhaps the most dangerous economic assumption of our time.

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  6. Re: "What is surprising to me is that relative to where it is today, the Fed's inflation-fighting credibility was still being earned as late as 1998. I was under the impression that Paul Volker came in and with one fell swoop earned the Fed the inflation-fighting credibility that it has today. The figure above suggests it was more of journey with inflation-fighting credibility being gradually earned over the next 17 years or so."

    That isn't how I would look at it. By my read, the Fed had plenty of inflation-fighting credibility by the late 1980's, if one reads "inflation-fighting" to mean "keeping inflation down to around 4 percent." As I remember, 4 percent was considered a reasonably low inflation rate at the time, and if the 10-year forecasts were available for that period, I think they would show a dramatic improvement in long-term credibility during the Volcker years. What happened subsequently is not so much that the Fed gained credibility (in the sense of confidence in its resolve to pursue a given inflation target) as that the Fed's perceived inflation target came down.

    I'm also hesitant about the interpretation of the recent data without having some measure of dispersion (ideally, both the dispersion among forecasters and the subjective dispersion of possible outcomes for individual forecasters). Has the Fed maintained it's inflation-fighting credibility over the past couple of years, or has a loss of inflation-fighting credibility merely been counterbalanced by a loss of deflation-fighting credibility? From a textbook Keynesian point of view (where the change in the inflation rate is determined by the amount of slack in the economy) it's hard to escape the conclusion that deflation is still a serious risk over the next 10 years.

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  7. Andy:

    Deflation prospects over the next 10 years? Wow. What makes you think there is that much slack?

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  8. If you use a linear Phillips curve with typical parameters and a NAIRU of around 5% (which was on the high side of estimates a couple of years ago), it puts us on a collision course with deflation. (As a typical example, the inflation rate might be reduced by one percentage point for every 3 percentage points that the unemployment rate is above the NAIRU for one year. With unemployment forecast to average around 10% in 2010 and fall slowly thereafter, this would give an inflation rate that falls to zero in 2011 and then keeps falling.)

    Granted, that's a very simplified and stylized way of modelling the Phillips curve. It could be non-linear, and the process of forming expectations could be more complicated than just taking last year's inflation rate, and there are other factors such as exchange rates and energy prices that are usually included, and the NAIRU can be expected to rise as prolonged stagnation reduces efficiency, and so on. Still, if you take the simple linear model at face value, the deflation gets quite ugly, and I don't think it's too far outside the realm of reasonable possibilities.

    There's also reason to be concerned that the slack will continue for quite a long time. Right now we have the fiscal stimulus and the inventory correction giving us a boost, but what happens after the stimulus peaks and the inventory cycle turns again? The housing boom was all that saved the US (and much of the world) from stagnation during the last business cycle. What will drive the growth phase this time? I can think of some candidates (green technology? more consumer demand and fiscal stimulus from developing countries?) but none of them inspire a huge amount of confidence.

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