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The Federal Reserve Needs Someone Who Understands Inflation

Tate Lacey

A worrying trend has developed among Federal Reserve officials
in the past month: They claim to no longer have a working theory of
inflation in the economy. This began at the September FOMC press
conference when Fed Chair Janet Yellen admitted, “The
shortfall of inflation from 2 percent … is more of a
mystery.” This is problematic.

It absolves the Fed from achieving one of their goals mandated
by Congress. Furthermore, a central bank that is both charged with
managing inflation and admits that inflation is a mystery has the
potential to lead to damaging policy decisions. As the president
considers a successor for Yellen, he should ensure the nominee
possesses a complete understanding of inflation dynamics and how
the Fed can and cannot affect them.

Maintaining stable prices — keeping inflation manageable
— is part of the Fed’s mandate. And in January 2012 the
Fed explicitly announced a 2 percent symmetric inflation target
saying it “is most consistent over the longer run with the
Federal Reserve’s statutory mandate.” Since then,
however, the Fed has consistently undershot that target.

A central bank that
claims to be without a theory of inflation dynamics runs the risk
of becoming a further destabilizing force when a shock hits the
economy.

The reasons for this undershooting have changed, but the
Fed’s performance has not. First, the Fed argued inflation
was low due to temporary factors that the central bank felt would
not materially affect the longer run. Then the Fed offered more
exotic explanations, citing lower cost wireless plans and
decreasing prescription drug prices, as forces holding down
inflationary pressures. Yellen has also discussed the so-called
“Amazon effect” in which the growing share of online
shopping holds inflation low.

The Fed technically could change this by injecting more money
into the economy, allowing that money to circulate and raise
inflation. Basic monetary economics says that the monopoly supplier
of currency is capable of generating nearly any amount of
inflation.

But excess money creation is dangerous. In the old operating
framework it led to uncomfortably high inflation throughout the
1970s. Society was forced to endure a good deal of pain as then-Fed
Chair Paul Volcker was forced to significantly raise interest
rates, thereby substantially increasing the price of credit, to
drain that excess money from the system.

Today, Fed officials are making the mistake of relying on the
Phillips Curve to guide policy decisions, and that is leading to
their confusion about inflation. The Phillips Curve says that when
the unemployment rate drops the inflation rate ought to increase,
and raise prices along with it. But this relationship is absent in
the data, something even Yellen has admitted.

Clinging to this outdated model is causing Fed officials to say
they’re without a working theory of inflation. To explain
this inflation “puzzle” they have cited supply-side
driven price changes. But trying to explain inflation with these
kinds of price changes may lead to the Fed inadvertently harming
the economy.

Here’s how that could play out: Were the economy to
undergo a boom in productivity, a welcome development, the drop in
prices would be a benefit to consumers. A positive supply shock of
this type would see a decline in measured inflation. Under
inflation targeting, falling prices would be a signal to the Fed to
cut interest rates. But excessive monetary stimulus creates its own
inflationary problems. It would be far better to let the price
change pass through and have consumers enjoy the lower prices.

Without properly understanding inflation, negative supply shocks
can cause even more problems than positive shocks. If prices rise
due to an oil shortage, this puts pressure on consumer budgets.
However, the inflation targeting central bank sees rising prices as
elevated inflation, and thus engages in tightening monetary policy.
This puts additional downward pressure on the economy.

Properly understood inflation is a monetary phenomenon and one
that the Fed can affect. This understanding of inflation is
different than supply-side effects on prices, which the Fed has far
less, if any, control over. And contrary to recent remarks from Fed
officials, understanding these differences does form a working
theory of inflation dynamics. In particular, such an understanding
highlights the dangers of reacting to all inflation and price
changes in the same way.

As he makes his selection, the president would be well advised
to ask potential nominees for their views on inflation, with a
special emphasis on how they would respond differently to different
shocks as Fed chair. Treating all inflationary pressures the same
can harm the economy, and the president needs a chair who’s aware
of this. A central bank that claims to be without a theory of
inflation dynamics runs the risk of becoming a further
destabilizing force when a shock hits the economy.

Tate Lacey is
a policy analyst at the Cato Institute’s Center for Financial and
Monetary Alternatives.