Don’t Trust the CPI – Inflation is Hidden Somewhere Else!

by Gunther Schnabl

Both in Europe and in the US, interest rates have fallen to still very low levels and central banks have used unconventional measures to stimulate the economy. Nevertheless, officially measured inflation rates have remained low. While central bankers are proud of the high degree of price stability, many citizens feel their purchasing power diminishing. How does this fit together?

Fed Policy and Velocity’s Dance

by Jerry O’Driscoll*

The U.S. economy has been growing slowly but steadily since the trough of the Great Recession in June 2009. Deep recessions are typically followed sharp recoveries. Not so this time.

More recently, there is the mystery of low inflation. The Fed’s preferred inflation measure, the core PCE index, has consistently fallen short of its target rate of 2 percent. In July 2017, it came in at a 1.41-percent annual rate. For the Fed, improved growth in employment and the falling unemployment rate should foreshadow a higher inflation rate. The rationale for this is the old Phillips Curve. The reality is that the model is flawed.[1]

Inflation Is Not Measured Correctly

by Gunther Schnabl*

The European Central Bank (ECB) continues buying securities. By the end of 2017, the balance sheet is expected to have further grown by about 800 billion euros. This corresponds to a growth rate of 20 percent per year, while real growth of the euro area is expected to be only 1.5 percent. Despite this tremendous monetary expansion, euro area inflation remains below the two percent target. This raises the question of whether the quantity equation, which Mark Blaug called “the oldest surviving theory in economics,” is still valid.

The Fed’s Institutional Design

by Gerald P. O’Driscoll, Jr.[1]

I have been reading Central Bank Governance & Oversight Reform, edited by John H. Cochrane and John B. Taylor. It is a conference volume of unusually high quality with all the discussions of presentations included.

I plan to write more about the book later, but to highlight one chapter here. It goes beyond the usual topics, covered well in the book, on rules versus discretion, credible commitments, policy legislation, and the historical record.

O’Driscoll on Inflation

by Mario Rizzo

ThinkMarkets blogger, Cato Senior Scholar, and former VP of the Federal Reserve Bank of Dallas, Gerald P. O’Driscoll, Jr., speaks on the Fox Business channel about the problems of deliberate inflation as a policy to reduce unemployment and spur growth. See the video here:

Gerald O’Driscoll on Inflation

The Return of Inflationism?

by Mario Rizzo

The Fed has become desperate, not because the American economy is currently falling apart, but because the economy has stubbornly failed to respond well to the policies of the “best and the brightest.” And now, as if to welcome the impending chairmanship of Janet Yellen, stories are surfacing in various places about the growing consensus inside and outside of the Fed for inflation. There is not enough inflation to stimulate adequate economic growth. Just a little more, or maybe even a lot more (perhaps as high as 6 percent) is needed as Ken Rogoff of Harvard is suggesting.

The arguments being used today are not exactly the same as those of the 1970s, yet I have the feeling that I have been here before.  It is important to distinguish theory from what policy economics is about. Policy economics often comes down to rather simple ideas. The real world has a way of making a mockery of today’s sophisticated macroeconomic theory. For one thing, policy has to be relatively simple if it is to be transparent.

The Euro: a Step Toward the Gold Standard?

by Andreas Hoffmann (University of Leipzig)

In a recent piece Jesus Huerta de Soto (2012) argues that the euro is a proxy for the gold standard. He draws several analogies between the euro and the classical gold standard (1880-1912). Like when “going on gold” European governments gave up monetary sovereignty by introducing the euro. Like the classical gold standard the common currency forces reforms upon countries that are in crisis because governments cannot manipulate the exchange rate and inflate away debt. Therefore, to limit state power and to encourage e.g. labor market reforms he views the euro as second best to the gold standard from a free market perspective. Therefore, we should defend it. He finds that it is a step toward the re-establishment of the classical gold standard.

There has been much criticism of the piece that mainly addresses the inflationary bias of the ECB. I actually agree with much of it. In particular, imperfect currency areas have the potential to restrict monetary nationalism. This can be welcomed just as customs unions that allow for free trade (at least in restricted areas). But I have some trouble with De Soto’s conclusions and the view that adhering to the euro (as did adhering to gold) gives an extra impetus for market reform – in spite of the mentioned e.g. labor market reforms in Spain.

Krugman Redistribution or Ponzi Scheme

by Chidem Kurdas

A nice thing about Paul Krugman, he does not mince his words. Thus his new book, End This Depression Now!, repeats as boldly as possible the central point he’s repeatedly made in his New York Times columns and blogs for years. Namely, governments have to spend a lot more. They have to run gigantic deficits, much more than they’re doing now. His penchant for going straight for the jugular means that the full implications of the scheme he advocates are crystal clear.

M. Friedman Goes to Washington

by Chidem Kurdas

Early in his career, long before he became a Nobel prizewinner and the household name for free market economist, Milton Friedman worked for the US Treasury. The following anecdote is from his 1998 memoir with his wife Rose, Two Lucky People.  This revealing example of how public officials operate illustrates, in Friedman’s words, “the interaction between bureaucratic self-seeking and supposedly objective analysis.”  It complements my previous post on whether politicians pursue the public good.

World War II had started. For Friedman and others at the Treasury, the main mission was to figure out how to finance the war effort while avoiding inflation. 

No Way to Escape for the Swiss National Bank

by Andreas Hoffmann and Gunther Schnabl

It came as a surprise to many: the Swiss National Bank announced an exchange rate target. Accordingly, the Swiss franc will be held above the level of 1.20 francs per euro. Switzerland gives up a part of its sovereignty, when the ECB makes bad press in buying trash-rated euro area government bonds to support unsustainable national budgets.

But, particularly in an environment of global excess liquidity originating in too-easy monetary policies in major advanced economies, small open economies have incentives to stabilize exchange rates.

Stark quits ECB

by Andreas Hoffmann

This is good news for inflationists.

I am shocked that Jürgen Stark quit his job at the European Central Bank. Usually it is a good thing when central bankers quit their job – or at least it does not make a difference. But Jürgen Stark is known as an inflation hawk. Jürgen Stark – like the Mark writes Die Welt.

In my opinion, the main difference between the ECB and the Fed is that the ECB has people like Stark. Unfortunately, there are only a few.

He is opposed to cheap money policies. A while ago, he openly warned of rolling bubbles caused by too low interest rates in the media. Thus, he suggested a timely turn-around in interest rate policy. Recently he voted against further bond purchases of the ECB. More on this recent event can be found here.

Coming shortly after Axel Weber resigned due to his disagreement with Trichet’s policies, Europe’s anti-inflation block is now shattered. Something terrible must be going on at the ECB. I wonder where the ECB is heading?

Where is the Bubble?

by Jerry O’Driscoll  

The monetary analysis of the housing bubble focuses on the impact of low – even negative – real rates of interest on housing demand.  That theory suggests the Fed must be inflating new bubbles with its continued policy of a near-zero federal funds rate. Skeptics ask where are the bubbles?

In today’s Wall Street Journal Business World column, Holman Jenkins answers with “Plane Crazy.” He specifically points to the recently announced deal in which debt-burdened and unprofitable American Airlines will take delivery of 460 new planes.  How did American pull this off?

Boeing and Airbus will share the order and each will finance a substantial portion of the purchase. “Think about it this way: Two rival banks get together and offer you a ‘no-doc’ mortgage for 115% of the value of your home,” writes Jenkins. He characterizes this as an opportunity for a “go-for-broke shot at a turnaround” for American. It’s an offer the airline could not refuse.

There are an ample number of other candidates for a bubble: gold, oil, farmland in the Midwest and perhaps the S&P. The entire world is awash in cheap dollars and much of the impact of the Fed’s policy has been to inflate bubbles overseas. That can be seen directly with the AA deal. More than half the order is going to Airbus, a European company.

The Fed’s easy-money policy was supposed to stimulate the U.S. economy and produce jobs for Americans. Fed policy has produced prosperity and jobs, just not in the United States.

Does one size fit all?

by Andreas Hoffmann

In a recent article in the WSJ, David Wessel sees a “fundamental problem” in the euro zone’s one-size-fits-all policy.

We know from Mundell (1961) that a one-size-fits-all monetary policy cannot guarantee low inflation and unemployment in all members of a heterogeneous currency area, given e.g. labor markets are not fully flexible as in the euro area.

In general, capital market integration and free capital flows in two regions have the tendency to bring about convergence of real – not necessarily nominal – interest rates (assuming no risk premium) as capital is allocated to its best uses. But in a currency area, like the euro area, nominal interest rates are the same everywhere as they are set by a central authority. Thus, real interest rates can be zero or even negative in regions that experience higher inflation, while they are positive in regions with lower inflation. Then policy is too expansionary in some regions and too tight in others, while the average inflation rate may stay relatively stable at the target level.

Easy Money, Emerging Market Miracles and the Revival of Industrial Policies

by Andreas Hoffmann and Gunther Schnabl

While most advanced economies continue to suffer from high unemployment and record debt levels, monetary expansions in the advanced economies feed a tsunami of carry trades, hiking asset and raw material prices and accelerating growth rates in emerging markets from Brazil over the Middle East to China. While capital inflows drive miraculous catch-ups in many corners of the world – having learnt the lesson for the recent mega-crisis – the monetary authorities in the emerging markets are aware of the risk of financial market exuberance. They aim to prevent inflation and bubbles by absorbing surplus liquidity and tightening credit growth.

Yet by doing so, they cause distortions in the real sectors of their economies, which are not on the radar screen of the now ballooning financial supervision bodies.

Let Them Eat Chips

by Jerry O’Driscoll

In today’s Wall Street Journal, David Wessel (“Capital” column, A5) revisits the question of whether current Fed policy is inflationary. He correctly states the Fed’s position is that inflation is caused by expectations. Inflation will stay low if people expect it to stay low.  He quotes Fed Chairman Bernanke: “The state of inflation expectations greatly influences actual inflation and thus the central bank’s ability to achieve price stability.”  

The Fed chairman of course has the causation precisely backwards.

Sand Castle Monetary Policy

by Mario Rizzo  

Chairman Ben Bernanke says don’t blame the Fed for rapidly increasing commodity prices and probable bubbles forming in many investment markets throughout the world. I am just doing what is necessary for a recovery in the US and that is in the interests of the world. (See “Bernanke Defends US Policies” Wall Street Journal, February 19-20).  

The reality is different.

Trouble ahead? Easy money vs. Turkey 1:0

by Andreas Hoffmann

While the US, Japan and Europe slashed interest rates to unprecedented low levels, growth remains sluggish. Dealing with debt problems and supporting the recovery, the ECB provided money to quasi-finance the euro area problem children. Similarly the Federal Reserve is trying to jump start the economy and has been flooding markets with money so that they have no idea about what to do with all the liquidity.

But – wait – there are emerging markets. They are booming from Brazil to Turkey. Hence, investors target emerging market asset markets until there is something to gain at home. As a consequence Poland and Brazil just raised interest rates to fight inflationary pressure in goods and asset markets. On the contrary, while inflation picks up (expected rate for 2011 is 5.9 percent), Turkey LOWERED interest rates and raised reserve requirements.

This might seem odd?

Inflation is Here

by Jerry O’Driscoll

 “Prices Soar on Crop Woes” reads the headline in today’s Wall Street Journal.

Global output of key crops such as corn, soybeans and wheat is down, and their prices are up, respectively, 94%, 51% and 80% from June lows. Today’s PPI report has wholesale prices up 1.1% in December after rising 0.8% in November. The Journal reminds us that in 2008 high food prices sparked riots around the world.

Meanwhile Fed officials tell us they don’t expect inflation.  It is not an issue of expecting inflation, but of observing it here and now.  The Fed prefers, of course, to look at “core” inflation rates, which are much lower. A former Fed colleague explained to me the central bank does so on the theory that people do not need to drive to work and can stop eating.

In our global economy, easy US monetary policy has thus far mainly affected commodity prices (including now food), real-estate in Asia and now broader price measures in Asia. It is implausible that the US would remain unaffected. Food, energy and clothing prices are all rising. I don’t think many households are presently gripped with a fear of deflation.

In the Mises/Hayek theory of economic fluctuations, the transmission of monetary shocks works through producer prices and incomes, and only later consumer prices. No measure of consumer prices, and certainly not a subset of consumer prices, is an adequate gauge of inflation.

Taylor, Krugman and Quantitative Easing

by Chidem Kurdas

In two substantial New York Review of Books articles, Paul Krugman and Robin Wells offer their views on various explanations of the property bubble and ways to get out of the slump.  On the latter front, they advocate aggressive deficit spending by the federal government and  quantitative easing by the Federal Reserve— No surprise to anyone who reads Professor Krugman’s writings.

Regarding the causes of the bubble, they favor the “global savings glut” explanation.  This view absolves the Federal Reserve from having spiked the punch bowl at the intertwined credit and real estate parties—by keeping interest rates exceptionally low from 2002 to 2005. It is remarkable that Krugman and Wells dismiss the case against the Fed without even bothering to mention the work that argues and presents evidence for the Fed’s pivotal role in causing the crisis—namely, Stanford professor John Taylor’s book and articles, including a Wall Street Journal piece.  

Why does this matter?

Up, Up and Away (Again)

by Bill Butos

Federal Reserve Chairman Ben Bernanke is pushing for another significant round of “quantitative easing” – now dubbed “QE2” by Fed observers – on the grounds that the economy’s response to simulative macro policies since 2008 has been anemic.  What the economy needs, this thinking goes, is some inflation.  While much of the public sees the run-up of  growth in government and exploding deficits as keys concerns, Bernanke,  continuing his soft stance on deficits, has argued that fiscal restraint would threaten the recovery.   Instead, he argues that monetary policy still has arrows in its quiver that should be used to lower the unemployment rate and rejuvenate the economy while also preempting the dreaded prospect of deflation . 

Austerity in Germany – A Keynesian Case

by Andreas Hoffmann*

The positions about economic policies could not have been more divided between Germany and the US during the latest G-20 summit.

On the one side, Barack Obama pushed Keynesian arguments about the need for further stimulus and the danger of austerity measures for economic recovery. On the other side, Miss “No” is back. Merkel promoted consolidation measures to prevent future debt crises and regain markets’ trust in sustainable government finance. And this time Merkel did not cave into US pressure.

I collected some arguments of why this may be a good idea:  

The European Central Bank Turns into the Fed?

by Andreas Hoffmann*

The European Central Bank (ECB) and the Fed differ in many aspects. First, the ECB is considered to be more hawkish on fighting inflationary tendencies. Its primary goal is price stability and it has continued to watch money growth. Output gaps below full-employment are only considered secondary as instrument to forecast inflation.

Secondly the ECB was constructed to be more independent than the Fed. Thus there has been less interaction with fiscal authorities. Less mobility from governments to the ECB (and vice versa) documents this independence. While in the US it is common to see central bank officials and the secretary of treasury plan the future of the economy, in Europe this is not the case. Central bank independence is considered an important aspect of credibility and stability of the currency (the German central bank model). However, the current crisis has made the ECB more “Anglo-Saxon.”

Hayek after 35 Years

by Jerry O’Driscoll  

Today I reread F. A. Hayek’s Nobel Lecture, “The Pretence of Knowledge.”  Hayek was awarded the Nobel Memorial Prize in 1974 and delivered his lecture on December 11, 1974. I was amazed at how modern it was, and appropriate once again for the times.  

The 1970s were terrible times: stop-go demand management policies had produced stagflation that would continue for the rest of the decade.  Hayek said that “we have indeed at the moment little cause for pride: as a profession we have made a mess of things.” He charged that the mess had been produced by policies the majority of economists “recommended and even urged governments to pursue.”  

The Fed’s Coming Indiscretion?

by Mario Rizzo  

There seems to be broad agreement among economists that the current recovery from the recession will be characterized by a slowly falling unemployment rate. This makes a good deal of sense since the problem that created the recession was a misdirection of resources into a number of sectors including housing construction and the financial industry.  

Reallocation of resources takes time. The government is not helping matters in trying to prevent adjustments by various (but not very successful) efforts to slow or reverse the rate of fall in housing prices. It is also difficult for market participants to determine the effect of possible new policies like Obamacare or any further jobs-stimulus legislation.  

Inflation as a Solution?

by Andreas Hoffmann*

The Wall Street Journal Online recently quoted an IMF paper (written by Oliver Blanchard), that a higher inflation may help to give leeway to monetary policy in times of crisis. What is this about?

Blanchard argues that if inflation rates are targeted at 4 percent rather than 2 percent, this would not make much difference. Following Blanchard, the ‘2 percent target’ is chosen ad hoc. Further, two additional percentage points of inflation would not do any/much damage (by e.g. increasing the volatility of an economy). On the other hand, as inflation adds to nominal interest rates, these would increase with higher inflation. Thus, the room for interest rate cuts will be larger potentially to stimulate the economy in times of crisis.