Good evening.
Time and again events remind us of the limitations of human rationality. Whether it’s the correct policy mix to bring down inflation, the more probable effects of climate change and realistic measures to address them, or geopolitical tilts that a short while ago seemed merely academic, examples abound where even the wisest among us find themselves grasping for not only clues but a better frame that might render a less wrong answer.
Take, for example, the current drama that is the central banks’ fight against inflation. There we have two parts to the problem. First, how you fight inflation depends on what you think has caused it. If overheated aggregate demand is the culprit, then hiking interest rates often does the trick, costing consumers more to borrow and businesses more to expand. But if constraints in aggregate supply are to blame, then fiscal policies are more useful, as they cause more to be produced and transported to where it’s needed.
And yet as Jason Thomas, Head of Global Research at the Carlyle Group, has observed:
When most analysts believed inflation was likely to prove “transitory,” official and quasi-official research organs emphasized the pandemic-related bottlenecks that temporarily inhibited supply from adjusting upward to meet demand. What really mattered in 2021 were the specific reasons inflation rose above target and why those factors would recede over time.
Now that inflation has endured longer than originally supposed, its origins are supposedly irrelevant. High inflation is now treated as a problem in general that tends to persist at elevated levels and can be very difficult to bring back down to target. Econometric specifications treat each instance of elevated inflation uniformly, making no distinction for whether it originates in pandemic, “clogged” supply chains, fiscal shock, energy crisis, or even sunspots.
But even batting away the distinction and assuming for a moment whatever led to high inflation, the right policy response is indeed interest rate hikes, the second part to the problem arises of how and when will we know the rates have hiked enough? Price signals take time to work their way through the financial markets then the real economy. Much as an ocean liner, the economy turns slowly even when a new course and bearings have been laid. Economists and central banks know this, of course, but that lag has rarely been accurately predicted. Each tightening faces a different economy, as is the specific execution of the policy itself.
Megan Greene of the Financial Times offers an example of how methodologies to predict monetary policy lag are far from settled wisdom:
Whenever there’s an economic consensus on anything, it’s worth considering how it might be wrong. There seems to be general agreement that inflation and rates will be higher for longer, and “team transitory” has been defeated. But what if we are at an inflection point on inflation? This is the question policymakers should be asking. By one key measure, inflation in the US has already peaked. In fact, it peaked in March, the same month that the Federal Reserve began raising the benchmark rate.
Greene is speaking to the New York Fed’s underlying inflation gauge (UIG), and explains how UIG is different from the more popular indices reviewed by the Federal Reserve and why it might be a better predictor:
The UIG is constructed differently, removing noise rather than items from the index. The idea is that movements in trend inflation happen alongside related changes in the trends of other economic and financial factors. The index looks at moves in prices, the labour market, financial markets and the real economy every month and checks the historical data going back to 1995 to see if similar moves had previously lasted at least a year. If so, they are included in that month’s UIG and if not, they are filtered out as noise.
You really can’t use the UIG to forecast the level of inflation, as has sometimes been suggested. Where it matters is in showing when the inflation trend is changing, and on this it has a decent track record in both normal and unprecedented times. When CPI hit a peak in 2018, for example, UIG clearly showed the peak while core CPI and trimmed mean and median indices suggested inflation would continue rising. In mid-2009, UIG showed a trough in inflation while the other measures took another year to reach a nadir.
A forward interest rate death march irrespective of the specific cause of inflation and without coordinated fiscal policies, though certainly effective in lowering inflation expectations, risks a devastating and unnecessary over-correction. Lessons from history demonstrate central banks must project willingness to crash the economy if it’s what it took to maintain the banks’ credibility in fighting inflation. However, as Ephesian philosopher Heraclitus once quipped: no man ever steps in the same river twice, for it’s not the same river and he’s not the same man.
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From Miami, Florida
Victor