Is High Inflation Likely?

The Statement

In his blog, Krugman dismisses the possibility of inflation. He goes farther and calls the Fed irresponsible for even considering the possibility of inflation. Krugman’s analysis is completely misleading over the prospects of inflation. He is using a backwards looking indicator that ignores changes in current policy. I too believe that high inflation outcomes are likely avoidable. Krugman seems to believe high inflation will be avoided even if the Fed leaves rates at zero forever. I believe that positive action (tighter policy) on the part of the Fed will be necessary to avoid inflation.

The Method

To see the difference in our beliefs, let’s work within Krugman’s framework. Krugman proposes the Taylor rule as his model of monetary policy and uses the parameters estimated by Glen Rudebusch at the SF Fed to judge the current, appropriate policy stance. Krugman uses the following Taylor rule:

Target fed funds rate = 2.07 + 1.28 x inflation - 1.95 x excess unemployment

Rudebusch’s weight on the unemployment gap is much higher than most other estimates. Taylor called for a coefficient of 0.5 on excess employment relative to a coefficient of 1.0 on inflation, implying the Fed should care twice as much about inflation as unemployment. Krugman believes the Fed should only care about 2/3 as much about inflation as the unemployment gap. The change in weights is quite significant.

In Krugman’s specification, with current inflation at -.02 percent (core PCE, 4-quarter change), the first two terms imply a Fed funds rate of positive 2.1 percent. The unemployment gap is then driving the current negative policy rate. With current unemployment around 9.8 percent (it was only 9.3 percent in Q2) and using the CBO’s pre-recession estimates of the NAIRU, the implied policy rate is very, very negative; indeed, much more negative than Krugman reports, negative 7.7 percent. If we had used more standard weights and a constant of 2, the implied policy rate is just barely negative, -0.5 percent.

But, to be honest, I am with Krugman and don’t see any justification for Taylor’s weights. The Taylor rule is not a model of the policy rate but was rather designed as a descriptive rule for understanding policy setting. Given this view, we are free to estimate rates and if I estimate the Taylor rule I arrive at coefficients closer to Glen’s than to Taylor’s.

The Mistake

If you think the Taylor rule was a good guide to policy in the past, the Fed shouldn’t start to raise rates until the rule starts, you know, yielding a positive number.

The first part of the quote is wrong and the second part puzzling.

The Taylor rule was not a good guide to policy in the past: The Taylor rule had been a good description of past policy. The two statements are not equivalent.

The Taylor rule is essentially a linearized equation from a specific model of Fed policy and inflation and resource slack. The Taylor rule does not describe a fundamental relationship between policy, output and inflation. There are many models of output and inflation.

In particular, we can modify Krugman’s Taylor rule to make it forward looking. An optimally behaving Fed will set policy not based on the past behavior of variables but rather on their forward-looking expectations.

Money Matters

For some reason many Fed officials seem to view it as inherently unsound to stay at a zero rate for several years running — but I’m at a loss to understand what model, or even conceptual framework, leads them to that conclusion.

Maybe some of the Fed officials remember the adage ardently espoused by Friedman: Inflation is always and everywhere a monetary phenomena.

Krugman, along with the rest of the Fresh Water economists, seem to have completely forgotten about the link between money and inflation. Lucas, Freidman, Smith, Hume, and yes even Keynes believed in a link between the quantity of money and inflation. Lots of money: lots of inflation.

Every scholar who has ever seriously examined the relationship between inflation and money has found a positive relationship. Lucas found a positive relationship using both U.S. and international data. Friedman found the same in 1960s for data sets running from the mid 1880s to the early 1960s. Both Hume and Smith believed in a positive relationship between money and inflation, although there use of data was more anecdotal and conjectural than rigorous.

The most recent study of inflation and money, of which I am aware, was presented last Thursday at a Federal Reserve conference. “Money and Inflation,” by Bennet McCallum and Edward Nelson, finds a consistent positive relationship between money supply and inflation: money raises inflation about 1-for-1 with a two year lag.

The Fed has increased the money supply substantially over the last two years. According to the Federal Reserve’s H.6 release, M1 has increased 18.6 percent over the past twelve months, while the broader M2 has risen 7.8 percent. These are extremely high growth rates. According to the work of McCallum and Nelson, this growth rate will lead to inflation one to two years from now.

If we replace Krugman’s backward-looking PCE with a reasonable forward looking expectation of inflation driven by the increase in the money supply, we find that between one and two years from now the policy rate had better be above 2 percent. Further, if we believe the results of McCallum and Nelson, the policy rate probably needs to start increasing now. That is, the money supply has to be reduced now to avoid the high inflation in the future.

This is the model policy makers likely have in mind when they call for tighter policy.

I don’t think there is any particular rush to raise rates. I think the Fed can afford to be patient and watch the data.

Conclusion

Krugman and I agree: There is very little likelihood of high inflation. Krugman believes in the Taylor rule and so a passive Fed can achieve this outcome. I believe in money and so an active Fed will achieve this outcome.

Krugman’s own Taylor series framework implies high inflation within one to two years, if the Fed is passive. Fortunately, the Fed is not passive. The Fed has the power to control inflation. It simply has to withdraw the liquidity in a timely manner.