Alleged Robust Evolution
A Non-Robust and Painfully Slow Evolution
Please consider A Robust Evolution by Richard Clarida.
As my FOMC colleagues and I indicated from the outset, the fact that the Federal Reserve System chose to conduct this review does not indicate that we believed we have been poorly served by the framework in place since 2012. Indeed, I would argue that over the past eight years, the framework served us well.
Three major bubbles of increasing amplitude and three severe recessions is not worthy of self-praise.
Phillips Curve Yet Again
Perhaps the most significant change since 2012 in our understanding of the economy is our reassessment of the neutral real interest rate, r*, that, over the longer run, is consistent with our maximum-employment and price-stability mandates.
Two other, related developments that have also become more evident than they appeared in 2012 are that price inflation seems less responsive to resource slack, and also, that estimates of resource slack based on historically estimated price Phillips curve relationships are less reliable and subject to more material revision than was once commonly believed.
The Phillips Curve, an economic model developed by A. W. Phillips, purports that inflation and unemployment have a stable and inverse relationship.
Simply put, as unemployment falls, consumer price inflation rises.
This has been a fundamental guiding economic theory used by the Fed for decades to set interest rates.
Former Fed chairs Janet Yellen and Ben Bernanke were both big Phillips Curve advocates despite the fact the theory never worked even according to Fed studies.
- August 29, 2017: Fed Study Shows Phillips Curve Is Useless: Admitting the Obvious
- January 15, 2019: Yet Another Fed Study Concludes Phillips Curve is Nonsense
The Phillips Curve isn't dead, it was never alive to begin with.
The Fed may finally grasp the notion that it based decades of policy on a concept that never worked.
But to mask over that idea, it gave itself fake praise.
Inflation, Uncertainty, and Monetary Policy
Please consider this snip from Inflation, Uncertainty, and Monetary Policy by then Fed Chair Janet Yellen on September 26, 2017.
In standard economic models, inflation expectations are an important determinant of actual inflation because, in deciding how much to adjust wages for individual jobs and prices of goods and services at a particular time, firms take into account the rate of overall inflation they expect to prevail in the future.
Clarida on Inflation Expectation
With that flashback out of the way, let's return to the more folly from Clarida on inflation expectations.
With regard to inflation expectations, there is broad agreement among academics and policymakers that achieving price stability on a sustainable basis requires that inflation expectations be well anchored at the rate of inflation consistent with the price-stability goal. This is especially true in the world that prevails today, with flat Phillips curves in which the primary determinant of actual inflation is expected inflation.
Inflation Expectation Nonsense
While finally admitting that the Phillips Curve is useless, the Fed shifted its focus to yet another totally bogus and easily disproved concept.
To understand why let's review the CPI makeup.
Inflation Expectations Q&A
Q: If consumers think the price of food will drop, will they stop eating?
Q: If consumers think the price of food will rise, will they eat twice as much or buy more than their freezer or pantry will hold?
Q: If consumers think the price of natural gas will drop, will they stop heating their homes and stop cooking to wait for the event.
Q:If consumers think the price of gas will rise, can they do anything about it other than fill up their tank more frequently?
Q: If consumers think the price of rent will drop, will they hold off renting until that happens?
Q: If consumers think the price of rent will rise, will they rent two apartments to take advantage?
Q: If people need an operation, will they hold off if they think prices might drop next month?
Q: If people need an operation, will they have two operations if they expect the price will go up?
Q: Will people stop paying their monthly phone bill if they believe a better deal might be available next year?
Housing, medical care, gasoline, food, auto repairs are all inelastic items. People will buy those those things and more at a steady pace no matter what their inflation expectations might be.
Even clothes are mostly inelastic. If someone needs a coat they generally will buy one and they won't buy another even if they expect prices will go up.
Yes, people shop sales, but they also don't hold off buying computers even though the price-performance ratio drops every year.
CPI a Flawed Measure
Moreover, the notion that one can measure inflation by the CPI is itself extremely flawed.
Ask anyone buying their own health insurance or paying college tuition about their measure of inflation.
Stupidity Still Well Anchored
The only thing that’s “well anchored” is the stupidity of the belief that inflation expectations matter.
People will rush to buy stocks in a bubble if they think prices will rise. They will hold off buying stocks if they expect prices will go down.
People will buy houses to rent or fix up if they think home prices will rise. They will hold off housing speculation if they expect prices will drop.
The very things where expectations do matter are the very things the Fed and mainstream media ignore.
BIS Deflation Study
The BIS did a historical study and found routine deflation was not any problem at all.
"Deflation may actually boost output. Lower prices increase real incomes and wealth. And they may also make export goods more competitive,” stated the study.
Central banks’ seriously misguided attempts to defeat routine consumer price deflation is what fuels the destructive asset bubbles that eventually collapse.
For a discussion of the BIS study, please see Historical Perspective on CPI Deflations: How Damaging are They?