Thursday, September 22, 2016

Rethinking Central Banking Policy

Textbook analyses of inflation make some assumptions that may be untenable.  Recent central bank policy in Europe, Japan and the US seems to be exposing problems with the way economists have been thinking about inflation.

Since the beginning of the 20th century, inflation in the US has not been much of a problem.  The brief spike in inflation in 1949 and the long upward swing in inflation in the 1970s stand out as exceptions to a broader, moderate, underlying inflation rate for nearly 120 years that has caused very little stir. 

The 1949 episode in the US seems easily explained as a reaction to the elimination of war-time price controls and the 1970s episode was likely a product of a combination of slow real GDP growth combined with a dramatic increase in money supply growth.  These episodes seem to have been exceptions.

Thus, the idea that a central bank can target inflation with minor tweaks in its own lending rates may be misguided.  If there are multiple equilibrium inflation rates, governed in the short run by expectations, then tinkering with central bank tools may not matter much.

For the real economy, central bank policy can do much mischief.  Loading up central bank balance sheets, as has been the pattern since 2008 clearly creates distortions, as did the horrendous, though probably inadvertent, Fed tightening policy of the 1929-1933 period.  But, it isn't clear, except in extremes, that central banks can do much about inflation in the short to medium term.

It took a while for Paul Volcker to wring inflation out of the American economy during his tenure as Fed Chairman from 1979-1987, but, once that was accomplished, inflation has been a very minor story in the grand scheme of macro-economic issues since.

If we could get central banks out of the news and put reins on their ability to dramatically alter their balance sheets, maybe we would all be better off.

Janet Yellen's press conference yesterday was muddled and incomprehensible.  News reports suggest Yellen's strange conference reflected wide differences of opinion among Fed governors.  Maybe this is much ado about nothing and the Fed should embark on unloading its absurdly large balance sheet gradually over time and quit pretending that it has much of a role to play in determining inflation rates and real GDP growth.

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