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Wonkblog’s Matt O’Brien had a great reminder last week that Eurozone policymakers’ obsession with low inflation is fueling a monetary policy that is extremely damaging to the broader European economy and the lives of millions of Europeans. A recent paper, though, suggests the problem may be even worse then we thought.

Jessie Handburt, Tsutomu Watanabe, and David E. Weinstein recently published a paper that purports to have assembled “the largest price and quantity dataset ever employed in economics” to assess how well the official Japanese CPI is measuring inflation. The answer is ‘not so good’ – but the reason for that answer is scary. To wit:

We show that when the Japanese CPI measures inflation as low (below 2.4 percent in our baseline estimates) there is little relation between measured inflation and actual inflation. Outside of this range, measured inflation understates actual inflation changes. In other words, one can infer inflation changes from CPI changes when the CPI is high, but not when the CPI close to zero.

What does that mean? They draw two clear conclusions. Firstly, that national CPIs routinely overstate inflation – here is their (better) measure stacked against the official measure:

the decline and fall of the nippon yenmpire

Since 1993, the official Japanese statistics show a net decline in prices of just a few percent, whereas the authors’ numbers show a decline close to 15%.

The other conclusion is that, even though over the long term the CPI overstates inflation, when inflation is low, the CPI is basically no better than a random guess as regards any particular measurement.

find the pattern [hint you can't]

This means that while, on average, the CPI inflation rate is biased upwards by 0.6 percentage points per year, one can only say with 95 percent confidence that this bias lies between -1.5 and 2.8 percentage points. In other words, if the official inflation rate is one percent per year and aggregate CPI errors are the same as those for grocery items, one can only infer that the true is inflation rate is between -1.5 and 2.8 percentage points. Thus, a one percent measured inflation rate would not be sufficient information for a central bank to know if the economy is in inflation or deflation.

you say toe-mae-tos (are more expensive) i say toe-mah-tos (aren't) let's call the whole thing off

In case it wasn’t clear enough, Europe is definitely in the ‘flying blind’ zone:


As is more and more of the developed world in general:

if all the other countries were blowing up their economies to satisfy a bizarre price stability fetish would you do it too?

This is, errr, kind of terrifying. Because what it all adds up to is the conclusion that monetary policy makers are throttling growth because they’re relying on data that is both inaccurate and imprecise. The inflation fears that have crippled Western recoveries for half-a-decade and running are based purely on phantoms.

Ryan Avent had a fantastic post Tuesday dismantling the rationale of the Fed, and specifically Jeremy Stein, for basically casting macroeconomic improvement to the wind for the sake of ill-defined financial stability. If you read Ryan’s post you’ll see precisely why this is backwards and, indeed, as likely as not to backfire.

The relatively meager contribution I’d like to make to the discussion is simply this – if the Fed truly believes that financial instability, despite being wholly absent from their legal mandate, is sufficiently important to trade off other desirable outcomes to pursue, then they should pick a target. One of the better decisions the Fed has made in recent years is more openly and rigorously defining targets – specifically, clearly defining the thresholds in widely-available and transparent measures of unemployment and inflation that may lead the Fed, once crossed, to raise interest rates, and disclaiming any potential rate raises before then. If the Fed wants us to take their approach to financial stability seriously, they should pick a variable or index and a threshold value and announce it. Absent doing so, we’ll all have to wonder whether less rigorous impulses undergird the Fed’s eagerness to find new reasons to raise interest rates even as unemployment is high and inflation low.

This one on Tyler Cowen’s confused/confusing post about QE exit:

Anyone confused about the effects of the taper has more than likely befuddled themselves out of the ability to see things clearly.

Unemployment is very high, labor force participation is low, and inflation is low. These problems tend to be solved by more money unless there is some supply-side constraint, especially in the energy sector, that would cause further monetary stimulus to be purely inflationary.

This is also a case where “use of wrong metaphor” is a pandemic memetic illness that is terminally crippling our ability to have this conversation. In recent years monetary stimulus has usually been phrased as the consumption of some short-term-pleasing but long-term-unhealthy substance to which the economic body begins building a tolerance, such as “sugar” or “heroin;” the latter especially harmonizes with the terminology prevalent in these discussions (“injection,” “withdrawal”). Yet this is, in fact, a poor metaphor for monetary policy except in narrow circumstances distant from those we currently occupy.

The correct metaphor for monetary policy is the steam engine of a locomotive. There is a correct amount of fuel to add to the engine; too much and it overheats, too little and it sputters and remains in place. The question to be asking is always “are we above or below the optimal point?” The current question – “how do we exit QE?” – is leading us down a very ominous path. Why do we inherently want to exit QE? Because hopefully it would signal economic recovery. But that does not mean exiting QE can cause recovery.

Now, monetary policy is of course more complex than a steam engine; the better metaphor is one that imagines a self-aware steam engine that can anticipate how much fuel it will likely receive in the future and can therefore reserve some portion of current fuel for future rather than present consumption. If we see the engine reserving substantial portions of fuel even as it is going slower than we’d like, that is not an engine that is on the path to regain the momentum to which we aspire.

Tyler Cowen on the shrinking labor force participation rate:

(And broken down by age here, I never find that disaggregation reassuring however, since the elderly are working more and the young less.)

Well, of course it is. More and more old people are working in white collar jobs. More and more old people are healthier and fitter in mind and body. More and more old people are still waiting for their 201(k)s to become 401(k)s again. And there’s just not enough demand to get you to full employment. So the least experienced, least skilled, least institutional-knowledge-endowed laborers are shut out of the workforce.

Conclusion: moar money, moar inflation, moar aggregate demand plz.

Sorry for the snark.


So I was trying to compare rates of business failures vs. unemployment during US recessions in FRED and coming up empty, but I did find this fascinating series:


Wonder what was happening in the early-to-mid 1940’s…


A simple problem – let’s say the central bank has a 2% inflation ceiling. Ergo, if it records inflation expectations as over 2%, it will take action to lower those expectations, usually raising interest rates as a way of draining the money supply, which also has the effect of decreasing total economic activity. Additionally, everyone knows this, so when some activities or events occur that would ceteris paribus increase inflation expectations markets presume the central bank will act to quash inflation and therefore adjust their overall expectations of economic activity. This will probably manifest itself as a reluctance to invest.

Let’s say unemployment is 10%, inflation is 1%, and real GDP growth is 1%. Let’s further say that the central bank is willing to tolerate an unlimited amount of RGDP growth but refuses to budget on its inflation ceiling. Let’s further say that any activation of idle labor will necessitate some inflation due to short-to-medium-run supply inelasticities. And let’s say everyone knows all of this.

Let’s say some large positive exogenous shock causes a boom in labor demand in some sector or another. This model would predict a largely zero-sum net gain in employment or economic growth, as the increase in activity in that sector will be offset by a decline elsewhere. The only net increase would be that commensurate with accommodating short-to-medium run supply inelasticities – that is, there can be some net gain every period, but only enough that it doesn’t push up prices very much.

Consequently, the Committee anticipates that the unemployment rate will decline only slowly toward levels that it judges to be consistent with its dual mandate.

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