Wednesday, November 14, 2007

A Crude Form of Inflation Targeting

In his latest sermon against core inflation, Barry Ritholtz makes an important point – sort of. At least, he brings up an important issue, but I think his message that the core is evil distracts him from thinking more subtly about the implications. The title of his post, “Rising Crude Oil Pushes Consumer Prices Higher,” says most of it, and when he says, “consumer prices,” he means, “even core prices.” It’s a fact that we can’t escape: energy is a critical input to many goods (and services) that are part of the core. And even if it is only targeting a core price index, the Fed still has to worry about oil prices.

This is, as I said, an important point, but I don’t think it implies that everyone who emphasizes the core is either a liar or an idiot. It just means that anyone who claims to make an optimal forecast of the core without taking oil prices into account is not being careful. It also means that, even if we are confident that the Fed is targeting a core index, we should expect the Fed to take into account the inflationary impact of large oil price increases. At the same time, the Fed may take into account the potential recessionary impact of rising oil prices, if it judges that the price increases are a supply-side effect and not a demand-side effect.

So the monetary policy implications of rising oil prices are ambiguous, but they clearly don’t follow the simple formula that the bond market sometimes seems to expect: tighter oil => weaker economy => easier money. If the change in oil prices is a demand-side effect, then it’s actually a symptom of a stronger economy rather than a cause of a weaker economy, and the formula goes something like this: stronger economy => tighter oil => tighter money. If the change in oil prices is a supply-side effect, it will unambiguously tend to weaken then economy, but the Fed may perhaps prefer an even weaker economy to an unchecked inflationary impulse, and the result may still be tighter money.

If it were up to me, the Fed’s target would not be core consumer prices but something (such as unit labor costs) that excludes the effects of energy shocks altogether. Such a target would allow the US to take an adverse energy shock entirely in the form of a higher price level (rather than going through the painful process of squeezing profit margins, which tends to have unemployment as a side effect) without raising long-term inflation expectations. (An abrupt energy shock could still weaken the economy by James Hamilton’s mechanism of forcing difficult transitions – squeezing profit margins in some areas while raising them in others – but I don’t think there’s much we can do about that.) Since unit labor costs seem to be a politically unacceptable target (and the data are unreliable in the short run), one could perhaps imagine a core price index that is corrected for the indirect effects of food and energy prices. (I guess that would piss Barry Ritholtz off even more.) I’d also like to exclude import prices, so the GDP deflator might be a reasonable first-round candidate, though it brings in another set of problems.

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Blogger Karl Smith said...

I am not sure that I agree here.

So, the central question is, "why do we care about inflation in the first place"

There are of course shoe leather costs, and the dynamic effects when prices are rising steadily but wages move in fits and starts. The curvature of the utility function then implies that some degree of smoothing will need to be done and that implies greater liquidity demand.

However, I think the big reason is that we need predictability in the bond markets. Inflation risk creates a credit wedge that destroys useful borrowing.

So my concern is whether or not inflation risks in the bond markets are contained. To wit, we need to be worried about whether long term return on bonds can be effected by unexpected changes in the price level.

Now, suppose we just target unit labor costs. In general we can break down costs, into labor, capital, natural resources and imported goods and services.

It would seem to me, though I haven
t crunched the numbers, that large movements in the price capital, natural resources and imports could significantly effect the price level apart from without impacting unit labor costs.

That is, labor share of national income could fall enough temporarily to introduce risk in the bond markets.

Now of course it is unlikely that trends in labor's share would continue over a protracted time. That is not, however, what it important. The question is can the big large enough and continue long enough to disrupt the yield on long term bonds.

If so we can't be satisfied with targeting unit labor costs.

Thu Nov 15, 10:25:00 AM EST  
Blogger knzn said...

I don't think that the inflation risk premium is such a big deal. In the late 1970s long-term real interest rates (by most measures) were negative even though inflation risk (the variance of expected inflation) was (by most accounts) perceived to be higher than in the past. Among the various things that affect the bond market, it would seem that there must be other issues much bigger than inflation risk.

I actually see very little cost to moderate inflation -- mostly menu costs, in the broad sense, meaning that it's just a pain in the neck to have to think in terms of a price level that is rising at a significant rate over time. The real cost is not in the realized inflation but in the unrealized hyperinflation. That is, as the distribution of possible inflation rates shifts to the right, the expected cost goes up, not because the cost of the mean goes up, but because the chance of very costly realizations on the far right side goes up. So what I want from a monetary policy regime is the least harmful way to prevent hyperinflation.

But I guess I care just a little bit about making the inflation rate predictable in the very long run, so I will choose a labor cost target over a wage target.

Thu Nov 15, 12:20:00 PM EST  
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