Friday, September 4, 2015

Revealed Preferences: Fed Inflation Target Edition

Over the past  six years the Fed's preferred measure of the price level, the core PCE deflator, has averaged 1.5 percent growth.  That is well below the Fed's explicit target of 2 percent inflation. Why this consistent shortfall?

Some Fed officials are asking themselves this very question. A recent Wall Street Journal article reporting from the Jackson Hole Fed meetings led with this opening sentence: "central bankers aren't sure they understand how inflation works anymore". The article goes on to highlight some deep soul searching being done by central bankers in the Wyoming mountains. It is good to see our monetary authorities engaged in deep introspection, but let me give them a suggestion. Dust off your revealed preference theory textbooks and see what they can tell you about the low inflation of the past six years. 

To that end, and as a public service to you our beleaguered Fed officials, let me provide some material to consider. First consider your inflation forecasts that go into making the central tendency consensus forecasts at the FOMC meetings. The figures below show the evolution of these forecasts for the current year, one-year ahead, and two-years ahead. There is an interesting pattern that emerges from these figures as you expand the forecast horizon: 2 percent becomes a upper bound.

So the first insight from revealed preferences is that you and your fellow FOMC officials have been consistently looking at an upper bound of 2% on core PCE inflation. Now if we add to this observation the fact that the FOMC has meaningful influence on inflation several years out, then these revealed preference are saying you want and expect to get an inflation upper bound of 2%

Your chair, Janet Yellen, conceded this point in the press conference following the December 2012 FOMC meeting:

But it’s important to point out that the Committee is not anticipating an overshoot of its 2 percent inflation objective (p.13).
Now an upper bound means there can be activity below it. And we see just that that in your inflation projections. Collectively, then, all of this revealed preference evidence suggests that you and your Fed colleagues do not have a 2% inflation target, but rather an inflation corridor target. Based on your above forecasts your corridor target appears to be somewhere between 1% and 2%. 

We can get a better sense of where this inflation corridor target lies with additional revealed preference evidence. This evidence is found in the following figure which shows core PCE inflation and the timing of your QE programs. The figure suggest that you and your fellow FOMC members tend to start QE programs after core inflation had been drifting away from the 2% upper bound and you do so in a manner that prevents it from drifting below 1% for very long. (Based on this reading, you all are likely to change tack soon if core inflation does not stop drifting toward 1%. )

This reading is corroborated by looking at the changes in the Fed's share of treasury securities as a percent of all market treasuries. Ever since the zero lower bound kicked in late 2008, the FOMC has tended to allow its share of treasury holdings to adjust in manner that offsets changes in core PCE inflation. That is, when inflation was falling the Fed started increasing its share of treasury securities and vice versa.

So rest easy dear Fed official. No need for any existential angst. According to revealed preferences, you are still driving core inflation--which ignores supply shocks like changes in oil prices--it is just that you have a roughly 1%-2% core inflation target corridor rather than a 2% target. So even though you may not realize it, you are doing a bang up job keeping core inflation in your target corridor.


  1. David, they sure are, but they could still do a lot better even while keeping inflation inside the "corridor":

  2. Prolonged payment of unemployment insurance can induce slackery , as we're constantly reminded by right-wing economists. Capitalist slackers are no different , but nobody ever reminds us about that. If capital accumulates steadily without any effort or risk , who would chance upsetting the applecart by investing in expansion or new ventures ?

    There's been plenty of inflation being generated , but you have to look at asset values to see it.

    Greenspan , Cochrane and others convinced Fed officials that if you built a nice net worth runway out of the sticks and stones of QE , the treasured GDP cargo would soon arrive. It's to the Fed's credit if they're beginning to see through this self-serving myth , if belatedly.


  3. Close to half of measured core CPI inflation has been shelter inflation, though I think the effect is less in PCE measures, which is why PCE inflation has been running lower than CPI inflation. A good portion of that shelter inflation is due to regulatory supply constraints in NY, San Francisco, etc., so it is a transfer to real estate owners, not a result of demand-side factors.

    If we use Core minus shelter CPI as the proxy for demand-side inflation, for 20 years, Demand-side CPI inflation has been moving in this range. For the past 2 years, it has fluctuated around a level just over 1%.

    1. So even core inflation is not fully supply-shock free. That is interesting and speaks to the whole measurement problem for inflation.

  4. I think Dean Baker makes a good point (repeated often) at his blog: You can't have an FOMC with so many ties to financial institutions-- with guys like Fischer having come from the major investment banks and one day returning to those banks-- and not expect them to be so biased toward so little inflation.They respond to incentives.

    1. Justin: Righto. Not really to the point of this post, and repeating myself, but:

      An extra point of inflation transfers tens, hundreds of billions of dollars in real buying power from creditors to debtors. Every year. Permanently. It's enough to get a fellow's attention.

      The Fed is run by creditors. Full stop.

      To the point of this post: yes, the Fed is doing its job of defending creditors' wealth -- at the expense of workers and valorous, risk-taking borrowers -- very very well.

    2. After extensive research of people who understand Fed motives with near certainty, I have decided there are 4 things we know.
      1) the Fed creates low inflation to help it's banker buddies.
      2) The Fed creates low inflation to keep wages down and help it's Wall Street buddies.
      3) The Fed shovels money into the economy to create bubbles for its Wall Street buddies.
      4) The Fed shovels money into the economy and then we use biased inflation measures to hide how much the cost of living is rising for workers.

      The facts are clear. No matter how you look at it, we can be certain that the Fed looks out for fat cats, workers be damned.

  5. Everyone , including Fed officials IMO , would like to see more inflation than what we've seen in the advanced economies since the crisis. The question is how to get there. Insanity is doing the same thing over and over , always expecting a different outcome. At least we should get a discussion fired up on alternatives , because we're likely to need them one day soon. This , just posted today , suggests a reasonable framework to build that discussion around :

    Also today , on Japan's experience :

    from the Conclusion :

    "....Japan suffered from deflation for more than a decade beginning at the end of the last century. More recently, Europe faces a threat of deflation. Our analysis suggests that it is difficult to combat deflation only by expanding the money supply. "


  6. “Dust off your revealed preference theory textbooks and see what they can tell you about the low inflation of the past six years.”

    Not being an economist, I’m always amazed by what seems like a galaxy of incredibly odd-ball jargon that is free floating though out the space.

    “Revealed preference” is one such phrase.

    Given the nature of your calling out of the Fed heads on this point, I’m particularly encouraged and relieved to say that your post makes quite a bit of sense to me.

    At last.

    A context for “revealed preference”.

    Suddenly I feel newly anchored.

    1. JKH, too funny. You are right that we often throw out economic jargon and assume our readers understand it. This post is no different. I failed to spell out exactly what revealed preferences meant. Fortunately, you were able to decipher it.

  7. One could argue that the committee is still targeting two percent inflation IF they also would have two percent as a "lower bound" if faced with an environment of higher than desired inflation.

    Granted, such an argument makes more sense when talking about longer-term forecasts, and IMO the "upper-bound" will at some point exceed two percent for shorter-term forecasts.

  8. And I'd also point out, isn't it the price index for personal consumption expenditures (which is different than either the core PCE or PCE) that is the preferred measure of inflation for the committee? By this measure, we have already exceeded 2% inflation this year.

    1. The core PCE I use above is the core PCE deflator or price index. I failed to use the word the 'deflator' so that may have caused some confusion. I had now adjusted the first sentence so that this point is clear.

  9. Excellent post. I blogged similarly over at Historinhas. The Fed, if it actually has a 2% target average, should now be shooting for 3% on the PCE To balance undershooting.

  10. Lack of understanding
    Comment on ‘Revealed Preferences: Fed Inflation Target Edition’

    You quote: “A recent Wall Street Journal article reporting from the Jackson Hole Fed meetings led with this opening sentence: ‘central bankers aren't sure they understand how inflation works anymore’."

    The fact of the matter is that central bankers never really understood inflation. This was not a problem, however, as long as their naive quantity theory seemed to work. We know from the history of science that false theories -- e.g. Aristotle’s theory of motion -- work satisfactorily in everyday situations. The falseness of false theories is invisible to the naked eye.

    The current economic situation is a clear refutation of both commonplace employment and quantity theory. The core of the unemployment/deflation problem is that the price mechanism does not work as standard economics suggests.

    This theory failure cannot be overcome by speculation about the FED’s motives. This second guessing invariably ends with the aha-insight ‘they’ serve themselves or their buddies.

    This misplaced psychologism obviously cannot explain inflation/deflation. Science works differently. The correct formula for the market clearing price in the simplified consumption good industry is given here

    Roughly, the formula says that the consumer price index declines if (i) the average expenditure ratio falls, (ii) the wage rate falls, (iii) the productivity increases, and (iv) the employment in the investment good industry shrinks relative to the employment in the consumption goods industry. The formula follows from (2014, Sec. 5).

    The crucial message is that the wage rate is the numéraire of the price system. If at all, the quantity of money plays an indirect role via the expenditure ratio and the employment relation of the investment good and the consumption good industry.

    The rule of thumb says: if wage increases for the business sector as a whole lag behind productivity increases deflation occurs (the rest of the price formula kept constant).

    Science is not about producing pointless behavioral speculation but about producing testable systemic laws. This is how economists could really help the clueless FED to understand inflation/deflation better.

    Egmont Kakarot-Handtke

    Kakarot-Handtke, E. (2014). The Three Fatal Mistakes of Yesterday Economics: Profit, I=S, Employment. SSRN Working Paper Series, 2489792: 1–13. URL

  11. Inflation's hedonics have changed over the last 30 years. It has gone very internationally and not so much nationally. Stripped out disinflation internationally is almost impossible. Then we have the silicons revolution on prices. Acting as a major deflation in industrial prices driving down costs across the board.

    That is why real gdp has probably been higher than what people think.