What causes inflation? Most people believe inflation is caused by central banks adjusting monetary conditions... But is this right? A recent study by some top economists has raised questions about this conventional wisdom.
The study found that the standard indicators... [like] economic slack, inflation expectations, and money growth were, in fact, unrelated to inflation. These findings caused quite a stir and even led the Wall Street Journal
to declare that “everything markets think they know about inflation might be wrong”.
This understanding misses, in my view, the deeper and more important point of the Cecchetti et al. paper. As the authors note in a separate blog post
, the lack of a relationship between the standard indicators and inflation is actually an indication that the Fed has done a good job in managing inflation:
While the USMPF report is titled Deflating Inflation Expectations, we do not conclude that expectations are unimportant. In fact, quite the opposite: the failure of measured inflation expectations to help forecast changes in inflation is probably a side effect of monetary policy’s success in stabilizing them.
This point, though, is a subtle one that is often missed by observers and that is why I wrote my piece for The Hill.
Drawing upon Nick Rowe's work
, I used the following example to illustrate the idea:
Imagine that the Fed is a driver, the economy is a car, the gas pedal is monetary policy and the car's speed is the inflation rate. The Fed’s objective here is to keep the car moving steadily along at 65 miles per hour.
When the car starts climbing hills, the Fed pushes further down on the gas pedal. When the car starts descending from the hills, the Fed lays off the gas pedal. Over many hills and miles, the Fed is able to maintain 65 MPH by making these adjustments to the gas pedal.
A child sitting in the backseat of the car who was oblivious to the hills but saw the many changes to the gas pedal would probably conclude the gas pedal has no bearing on the speed of the car. After all, no matter what happened to the gas pedal the car’s speed never changed.
As outside observers, we know better. We know the driver was adjusting the gas pedal just enough to offset the ups and downs of the hills so that a constant speed was maintained. In terms of our Fed analogy, monetary policy was adjusted just enough to offset the ups and downs of the economy so that a stable inflation rate was maintained.
So many people have failed to grasp this point, especially over the past eight years. The Fed got the inflation it wanted over this period by pushing the gas pedal--QE and low rates--just enough to offset the drag of the Great Recession on the price level. Although the Fed wanted a quick recovery, it wanted even more to maintain stable and low inflation. This is evident in their core inflation projections in the FOMC's Summary of Economic Projections (which always saw 2% as ceiling) and in the FOMC's revealed preferences.
This meant the FOMC was not willing to allow an inflation overshoot which, in addition to making their inflation target symmetric, would have allowed more rapid catch-up growth in aggregate demand. As I have said elsewhere, this was the Fed's Dirty Little Secret
: its policies were never going to create a robust recovery given the Fed's asymmetric approach to inflation targeting.
But I digress, the point of this post is to remind us that analyzing monetary policy is hard. One cannot simply draw conclusions by looking at interest rates, output gaps, money growth and comparing them to inflation Depending on how the Fed is conducting monetary policy, these indicators should be uncorrelated with inflation if the Fed is doing its job.
Given the importance of this idea, I have excerpted an earlier post on this topic below the fold.