Politics & Policy

Day-Late, Dollar-Short Fed

A price rule was all the central bank needed.

Higher-than-expected inflation (core inflation is running near a 3 percent rate for the first three months of the year) and a stronger-than-expected payroll report have sent shockwaves through the stock market. Do these unexpected numbers signal a higher inflation rate during the coming months? Will the Fed lose the “patience” it showed when it said “policy accommodation can be maintained for a considerable period”? Is a rate hike around the corner, and if so how far around the corner?

In order to get a sense of the likely Fed response to the current environment, I decided to review the frameworks commonly used to gauge a rise in inflationary expectations and a pending increase in interest rates.

Looking at the U.S. economic data, one glaring fact emerges on my review: None of the traditional inflation indicators have worked very well in this economic cycle except for the one that mattered — the actual price level, which is to say a result consistent with a domestic price rule.

So, when the Fed departs from the price rule, it must be difficult for economic analysts to anticipate the future — right? Not necessarily. The organization of the monetary system and the economic persuasion of the day determine the nature of the policy response to slack and/or inflation in the economy. This makes the task of forecasting future inflation a bit easier.

Keynesians, of course, subscribe to the Phillips curve. According to the textbooks, as the unemployment rate declines, bottlenecks are developed which in turn lead to higher prices. Since the unemployment rate is inversely related to real GDP growth, the Phillips curve posits a positive relationship between the inflation rate and real growth of gross domestic product.

The Keynesian/Phillips curve crowd also postulates a positive relationship between money growth and inflation. In the simple Keynesian model the transmission mechanism operates initially through a reduction in the real interest rate. Higher money growth leads to lower interest rates, producing higher demand in the economy resulting in higher real GDP. In turn, the higher output increases manufacturing capacity utilization which creates production bottlenecks that result in higher prices.

All this Keyensianism is contradicted by the data.

The inflation rate peaked during the 2001 recession when real GDP growth was at its lowest. As the economy recovered, the inflation rate declined. The data, in fact, uncovers a negative relationship between growth and inflation, which is the opposite of what the Philips curve predicts.

Then there’s interest-rate targeting — the Keynesian version of the price rule. The thinking here is that by controlling interest rates the Fed can control real GDP growth and the inflation rate.

This is an activist model and it plays out theoretically in this manner: By keeping interest rates below their long-run full-employment/price-stability levels, demand in the economy will increase, moving the economy closer to its full-employment level. At some point in time, as a result of a low-interest-rate policy, the economy overshoots its full-employment level and inflation heats up. At this point the Fed is forced to raise interest rates in order to slow the economy and rein in inflation.

A forward-looking Fed attempts to correct for any undesired economic condition that it anticipates. Therefore, it will lower interest rates if it expects the economy or the inflation rate to slow and raise interest rates if it expects the economy to grow above what it considers the “speed limit.” It is in the context of this activist model that one can provide a simple interpretation of the economic data during the last few years:

The low and declining inflation rate during the 2000-02 period combined with declining real GDP growth in 2000-01 would, under the Keynesian interest rate targeting approach, prompt the Fed to lower the fed funds interest rate. The weak recovery during 2002 would do nothing to alter the Fed’s stance, and the surge in real GDP during 2003 could have sent the Fed a warning signal. However, low inflation rates and the lack of employment growth convinced the Fed to stay on its easy-money course.

Yet the previous interpretation is too favorable to the Fed. It assumes perfect foresight — the ability to anticipate and preempt adverse economic conditions. The exact timing of the Fed’s actions suggests a slightly different view.

A consensus seems to be emerging that the last recession began late in 2000. Yet as the economy was weakening, the Fed was raising the fed funds rate. If anything, this suggests that the Fed made a forecasting mistake and added to the economic slowdown that was taking place at the time.

Once the recession hit in earnest the Fed acted vigorously to inject cash into the economy — and for this they deserve kudos. But the data suggest that on average the Fed was a little late on the timing.

Monetarist models — which define inflation as too much money chasing too few goods — do better then Keynesian models. The major distinguishing difference between the Keynesian and monetarist frameworks is the relationship between inflation and real GDP growth. Where Keynesians expect a positive relationship, monetarists posit a negative one — and as shown above the data proves the Keynesians flat-wrong on this front.

But then there’s the price rule, which unlike our current Fed is never late. The thinking here is that whenever prices or inflation rise above the target range, too much money exists in circulation. The Fed can reduce this excess money through open-market operations (i.e., by selling government bonds in the open market, thereby reducing the quantity of high-power money circulating in the economy).

In the same way, in the event of an increase in the demand for money, which creates a downward pressure on the price level, the Fed is forced to buy bonds, increasing the quantity of high-powered money circulating in the economy. Under a price rule real GDP growth and the quantity of money are positively related. More importantly, real GDP and money growth will both be uncorrelated with the inflation rate.

The current Greenspan Fed has lagged in its reactions to the real economy, compounding monetary mistakes. It put the brakes on the economy when it was beginning to recover, and the inflation rate fell below that of the 2 percent target range. Then it pushed the economy to the brink of deflation when it violated the price rule by not being accommodative enough. By deviating from the price rule, the Fed has too often been caught a day late and a dollar short.

With all this in mind, let’s go back to the big question at hand: How will the Fed react to rising inflation and how soon?

The Keynesians would see it this way: The higher inflation rate, strong real GDP growth, and barn-burner payroll reports all point to an overheating economy which will necessitate a rise in interest rates to cool it down. Add some interest-rate targeting to the equation and the Keynesian framework would call for a rate hike sooner rather than later.

Monetarists interpreting the same data would reach a slightly different conclusion: Stronger economic growth will, all else the same, result in a higher real interest rate and lower inflation. But the monetarists would expect the Fed to avoid placing any adverse risk on the economic recovery that would reduce the chances of the inflation rate declining. So the monetarist model would also predict a rising interest rate.

Finally, the price rulers, a.k.a supply-siders, would argue that higher real growth will lead to a higher real rate of return. Once again, nominal interest rates will have to rise.

It’s very unusual to have Keynesians, monetarists, and supply-siders agreeing on the future path of interest rates. But they do — so only contrarians would bet against a rate hike in the near future. And sooner rather than later.

– Victor Canto, Ph.D., is the founder of La Jolla Economics, an economics research and consulting firm in La Jolla, California.

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