Friday, March 3, 2017

What's Up With Inflation?

In the past year, inflation rates have increased in a number of countries. Are these increases temporary or permanent? What do they imply for monetary policy?

One of the more stark turnarounds in inflation performance is in Sweden. To see what is going on, it helps to look at CPI levels:
Sweden had four years of inflation close to zero, but in the last year prices have been increasing, and the current 12-month inflation rate is 1.4%, which is getting much closer to the Riksbank's 2% inflation target. The path - actual, and projected by the Riksbank - for the Riksbank's policy interest rate looks like this:
So, the Riksbank's policy rate has been negative for about two years, and it envisions negative rates for the next two years.

For the Euro area, the story is similar. Here's the Euro area CPI:
The difference here, from Sweden, is that the inflation rate has been at zero for only three years, but you can see a similar increase in the inflation rate in the last year, with the current 12-month Euro area inflation rate at 1.6%. And the overnight interest rate in the Euro area looks like this:
As you can see, overnight nominal interest rates entered negative territory in 2015, and went significantly negative last year.

Another instance of increasing inflation is the UK:
In this case, it's more like two years of inflation close to zero, followed by an increase in 2016. The current 12-month inflation rate in the UK is 1.9%. The Bank of England's policy interest rate was targeted at 0.50% from March 2009 to August 2016, when it was reduced to 0.25%.

What's the most likely cause of the increase in the inflation rate in these three countries? I don't think we have to look far:
Crude oil prices fell from $100-110 in mid-2014 to about $30 in January 2016, and have since increased to $50-55. While changes in relative prices should not matter in the long run for inflation, a strong regularity is that, in the short run, shocks that cause large relative price movements are reflected in changes in inflation rates. As is well-known, that's particularly the case for crude oil prices, which are highly volatile and tend to move aggregate price indices in the same direction.

The timing certainly seems to suggest that oil price increases are responsible for the increase in inflation in Sweden, the Euro area, and the UK. But, of course, the monetary policies of the Riksbank, the ECB, and the Bank of England were specifically designed to increase inflation. These policies included low or negative nominal interest rate targets and large-scale asset purchases by the central bank. Most of the central bankers involved tend to subscribe to a simple Keynesian story: inflation expectations are fixed (i.e. "anchored"); lower interest rates reduce real rates of interest, which increase spending, output, and employment; inflation increases through a Phillips curve effect. Why can't we always see these effects? True believers might appeal to "long and variable lags" and a "flat Phillips curve." Those are dodges, I think. IS/LM/Phillips curve isn't a helpful framework for thinking about monetary policy if I have to worry about whether it's going to take six weeks or six years for monetary policy to work, or if I need to be concerned whether the Phillips curve is just resting, flat, sloping the wrong way, or deceased.

Further, there are countries in which extreme forms of negative interest rate monetary policy and a large central bank balance sheet don't appear to have moved inflation in the desired direction. One is Switzerland. Here's the Swiss CPI:
So, the recent history in Switzerland if one of unabated trend deflation. And overnight interest rates in Switzerland look like this:
Next, since April 2013 the Bank of Japan has resorted to every trick in the book (massive quantitative easing, low and negative nominal interest rates) to get inflation up to 2%. Here's the result:
I've told this story before, but it bears repeating. Since the BoJ's easing program began in April 2013, most of the increase in the CPI level has been due to an increase of three percentage points in the consumption tax in April 2014 in Japan. Inflation has averaged about zero for almost three years.

What's the conclusion? For all these countries, recent data is consistent with the view that persistently low nominal interest rates do not increase inflation - this just makes inflation low. If a central bank is persistently undershooting its inflation target, the solution - the neo-Fisherian solution - is to raise the nominal interest rate target. Undergraduate IS/LM/Phillips curve analysis may tell you that central banks increase inflation by reducing the nominal interest rate target, but that's inconsistent with the implications of essentially all modern mainstream macroeconomic models, and with recent experience.

But, even if we recognize the importance of Fisher effects, that will not make inflation control easy. (i) Shocks to the economy - for example large changes in the relative price of crude oil - can push inflation off track. (ii) The long-run real rate of interest is not a constant. As is now widely-recognized, the real rate of return on government debt, particularly in the United States, has trended downward for the last 35 years or so, and shows no signs that it will increase. By Fisherian reasoning, a persistently low real interest rate implies that the short-term nominal interest rate consistent with 2% inflation is much lower than it once was. But what's the best guess for the appropriate nominal interest rate currently, in the United States? Here's the inflation rate, and the 3-month T-bill rate in the United States (I'm using the T-bill rate to avoid questions as to what overnight rate we should be looking at):
So, the Fed's preferred measure of inflation (raw PCE inflation), at 1.9%, is very close to its target of 2%, after two interest rate hikes (in December 2015 and December 2016), which some claimed would reduce inflation and/or push the economy off a cliff. Looking at this same data in another way, subtract the 12-month inflation rate from the 3-month T-bill rate to get a measure of the real interest rate:
So, from mid-2012 to mid-2014, the real interest rate averaged about -1.3%, before oil prices fell. Now that the price of crude oil has again increased somewhat, the real interest rate is back in that ballpark again, with inflation close to the 2% target. So, what would a neo-Fisherian do? (i) There's no good reason to think that oil prices will keep going up, so the effects of the recent oil price increases should dissipate. So, with no change in monetary policy, we might expect a small reduction in the PCE inflation rate. (ii) There's no good reason to anticipate an increase in the long-run real rate of return on government debt, given our knowledge of what makes the real interest rate low (a shortage of safe assets, low average productivity growth). Therefore, a neo-Fisherian inflation-targeting policy maker might want another 1/4 point increase in the fed funds target, but not much more.


  1. Larger, diversified economies should try NGDP level targeting, or something similar. This idea is endorsed by New Keynesians such as Woodford and Christina Romer.

    Less diversified economies can try some form of nominal wage targeting or, in the case of export-dependent countries, exchange rate targeting.

    I agree that the old Keynesian framework is of limited value.

    1. Yes, it's easy to find people who think NGDP targeting is a good idea. I've never been convinced. At best, it's just a special Taylor rule, but no one has made a convincing case for it, I think.

    2. What about this paper?

    3. That's a particular model, and the authors don't derive an optimal policy rule - they're just comparing NGDP targeting to other suboptimal rules. I could imagine environments in which NGDP targeting could go very wrong. For example, suppose at the extreme that all the welfare losses are coming from unanticipated inflation, and that the central bank can determine inflation at will. Also suppose that there are some shocks that make real GDP fluctuate, and that central bank policy only affects inflation, not real GDP. Then, inflation targeting is really good, and nominal GDP targeting is really bad. Indeed, if you look at the observed variability in nominal GDP about trend, most of that is coming from variability in real GDP. That's in part because central banks are good at reducing the variability in inflation. Nominal GDP targeting could only be a good idea if there are large nonneutralities of money and inflation variability matters little. I don't think either is the case.

  2. The reason that Switzerland's inflation appears to fall just after the cut in nominal policy rates is that the cut happened at the same time the SNB abolished the floor on the Swiss Franc, which resulted in a large appreciation. Ascribing it to neo-Fisherian effects is equivalent to looking at the UK/Swedish/Euro Area experience and rejecting neo-Fisherianism by ignoring oil.

    While these charts might be consistent with neo-Fisherianism, they are also consistent in a world where the Central Bank anticipates the future evolution of inflation and adjusts interest rates of offset this (in a "conventional" policy way of thinking). Sadly, macro data is not that informative..

    1. Well, open economy considerations certainly complicate things, but the exchange rate is endogenous, and typically we think of a country, such as Switzerland, with a flexible exchange rate, as having an independent monetary policy which can achieve an inflation policy independent of the rest of the world. And, according to modern monetary policy implementation, that's done by setting an overnight nominal interest rate target. The SNB likes to conduct monetary policy, in part, so as to manage its exchange rate relative to the Euro. Here's what the SNB thinks it's doing (from its policy assessment): "The SNB’s expansionary monetary policy is aimed at stabilising price
      developments and supporting economic activity. The negative interest rate and the SNB’s
      willingness to intervene in the foreign exchange market are intended to make Swiss franc
      investments less attractive, thereby easing pressure on the currency. The Swiss franc is still significantly overvalued."

      So, it's clear they think low nominal interest rates make inflation go up, and will cause the Swiss Franc to depreciate. But it's not happening the way they want it to. Seems consistent with neo-Fisher to me.

  3. In your opinion, is there any value in the argument that the shock to expectations following the GFC is still being felt?

    Why is this not a consideration?

    1. I'm not sure what you mean. What is the "shock to expectations," and how should it matter?

  4. It seems to me consumers and businessmen, as a result of the collapse of financial markets in 2008 have been very cautious in spending, seeking in the first instance to deleverage and having a negative outlook on the future. This negative outlook and hesitancy has taken literally years to dissipate.