Saturday, September 16, 2006

Bernanke vs. Baum

Fed Chairman Ben Bernanke argues that targeting core inflation is appropriate because, otherwise, the Fed would have to “force down wages and other prices quite dramatically to keep the overall price level from rising” in the face of rising energy prices. Bloomberg columnist Caroline Baum (hat tip: Mark Thoma) objects:
In order to offset the immediate effect of a rise in energy prices, the Fed wouldn't have to do anything. The price of something else would fall, all things equal, as consumers adapt to the constraints on their budgets (paying more for gas means less money for other goods).
I have (at least) four problems with Ms. Baum’s argument.

First, I have a basic philosophical problem with clauses like “the Fed wouldn't have to do anything.” What exactly is meant by not doing anything? I suppose they could hang “Gone Fishing” signs on the doors of all the Federal Reserve Banks and tell all the employees to go home and be with their families for a few months. No doubt this would succeed in getting prices down, but I don’t think it’s what Ms. Baum has in mind. It’s really quite arbitrary what course of Fed action is defined as being passive. Keep the monetary base constant? Keep the interest rate constant? Increase the monetary base at a 2% annual rate? At a 10% annual rate? Follow a Taylor rule? Ms. Baum’s whole argument is premised on the idea that there is some “default” course for the Fed. But who gets to define that default? No doubt she can define the default in a way that will produce, on average, the results she imagines, but someone else will define the default differently.

Second, let’s accept the default that she perhaps has in mind, maybe some ideal constant money growth rule, and let’s assume away all the uncertainties about velocity of money and potential output. Increases in the average price level are caused, according to the cliché, by “too much money chasing too few goods.” Ms. Baum assumes that “too much money” is the problem. In the case of energy, however, it is more likely “too few goods.” In other words, if the Fed were following a passive money supply rule, an adverse oil shock would cause the average price level to increase anyhow. If oil becomes scarcer but money remains equally plentiful, the value of money – in terms of some basket that includes oil and products made with oil – will go down.

Third, even if my first two objections didn’t apply, let’s just imagine that Bernanke is using imprecise language by casting the Fed’s behavior as active rather than passive. Let’s say it is not the Fed but the market that has to “force down wages and other prices quite dramatically to keep the overall price level from rising.” That’s still a bad thing, because most wages and prices don’t go down without a fight, and the fight usually takes the form of a recession. The Fed is willing – actively or passively, depending on your economic theory and your semantic preferences – to accept temporary increases in the headline inflation rate in order to avoid unnecessary recessions. That strikes me as not only good judgment, but also the clear duty of the Fed under its current mandate.

Finally, let me make a basic point about the nature of oil as a commodity: oil is storable. If the price of is expected to rise, there will be strong incentive (provided that storage costs and interest rates are not too high) to hold large inventories in anticipation of higher prices. In practice, we never observe huge inventories, because producers, facing expected price increases, choose to delay production, which causes prices to increase immediately. In any case, the nature of the oil market is such that, normally, the most knowledgeable people will never, on average, be expecting large price increases. Otherwise, those price increases would already have happened. If the Fed’s objective is to stabilize prices going forward, then the Fed is operating well within reason to assume that oil prices will not rise dramatically. It is taking the market’s judgment, effectively outsourcing the task of forecasting oil prices. Past increases in oil prices are irrelevant, and it is rational for the Fed to ignore them by using core inflation as its measure of past price growth.

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Blogger Gabriel Mihalache said...

Her point looks like a failed attempt at general equilibrium reasoning. Following a change in a relative price, a new equilibrium will imply changes in other prices AND changes in quantities. But then she violates this second point by proposing an argument in which output is kept constant. She says, basically:

m + v = p + y
0 + 0 = p + 0


y + 0 = p + y

in which case p = 0 regardless of a change in a price which washes out in the weighted average.

Sat Sep 16, 11:45:00 AM EDT  
Anonymous William Polley said...


We don't really have a handle on how long it takes for these shocks to work their way through (see Yellen's speeches, for example). But Dave Altig's post the other day gives me a reason to think that we might (I repeat, *might*) be over the hump. I think Dave wants to believe but remains cautious.

If true, it would also tend to weaken Baum's argument. In the long run we may not all be dead, but we might be 3 years older. (3 years being a political eternity)

Sat Sep 16, 12:45:00 PM EDT  
Blogger knzn said...

Yes, I didn’t buy her empirical argument. Basically: if the inflation rate hasn’t come down yet, it’s not gonna. If you see housing as the primary transmission mechanism, then the Fed’s tightening since 2004 is only this year beginning to affect the economy significantly. (The housing boom was still going on through the end of 2005.) So I would give it at least another year before declaring that the Fed has failed to keep inflation under control.

Sat Sep 16, 07:22:00 PM EDT  
Blogger Gabriel Mihalache said...

If I remember correctly, most inflation targeting "deals" specify 18-24 months as an acceptable interval to bring inflation down, back to target band. Of course, the Fed is not targeting, in the full sense of the word, but the time-frame might still apply. In other words, 2007Q1 might be a better time to draw conclusions.

On the other hand, her arguments seems more theoretical than empirical to me.

Sun Sep 17, 07:25:00 AM EDT  
Blogger Laurent GUERBY said...

knzn, just curious, what the fed does other than setting the short term rate these days?

Sun Sep 17, 11:26:00 AM EDT  
Blogger knzn said...

In theory, they also set reserve requirements, although I don’t think those have been changed in quite a while. And they have various regulatory functions and conduct various research. And “setting the short term rate” involves a lot more activity than one might think, because it requires anticipating changes in money demand that might cause unintended changes in the interest rate.

But the interest rate is indeed what they use as a policy instrument these days. I was giving Ms. Baum the benefit of the doubt by assuming she meant a constant money growth rule. If the Fed held the interest rate constant in the face of an oil shock, I believe it would be extremely inflationary, as I discussed in my comment to Gabriel’s post (see link below).

Sun Sep 17, 07:24:00 PM EDT  
Blogger Laurent GUERBY said...

knzn, thanks for your precisions.

I know that setting rates in work-intensive, a friend of mine worked at the ECB team in charge of anticipating money demand for a few monthes :).

I've always wondered why central banks aren't using reserve requirement. In my simple mental model, raising rates will annoy everyone needing money, whereas raising reserve requirements will annoy mostly banks (and not people going to seek savings with investment opportunities on the markets, with shares, bonds or CBs). So when you think banks are helping the making another asset bubble, why not just raise the reserve requirement to send the message: "banks, bad!" without pissing off too much the rest of the economy.

Note: on the regulatory activities, if central banks did only that no economist would talk about central bank activities except for saying "too many regulation" "must let industry regulate itself", "stiffling growth", etc... :)

Mon Sep 18, 04:56:00 PM EDT  
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