View Full Version : Will Moderating Growth Reduce Inflation?

12-22-06, 05:33 PM
Will Moderating Growth Reduce Inflation? (http://www.frbsf.org/publications/economics/letter/2006/el2006-37.html)
December 22, 2006 (FRBSF Economic Letter)

The December 12, 2006, statement of the Federal Open Market Committee (FOMC) said, "Readings on core inflation have been elevated, and the high level of resource utilization has the potential to sustain inflation pressures." The link between "inflation pressures" and the "level of resource utilization" is formalized by the Phillips curve, which says that short-term movements in inflation and unemployment (a measure of labor resource utilization) tend to go in opposite directions. For example, when strong economic activity makes the labor market tight, inflation is likely to increase. Technically, "tightness" in the labor market means that the unemployment rate is below its natural (or equilibrium) rate, a measure that is not directly observable but is derived from estimates. Pioneering research by economists Edmund Phelps and Milton Friedman during the 1960s asserted that monetary policy could not keep the unemployment rate permanently below the natural rate--a view that is now universally accepted. Phelps is the most recent recipient of the Nobel Memorial Prize in economic science. Friedman was awarded the same prize in 1976.

AntiSpin: Sounds like the author is buying into the notion of using the delta between the so-called "natural rate of unemployment" versus the current rate to determine future inflation. But not so.

Read on and the Fed says:
Numerous research studies have demonstrated that forecasts of U.S. inflation based on empirical Phillips curve models can frequently underperform simple alternative forecasts that only employ data on inflation itself. A naive random walk forecast says that future inflation will be the same as current inflation. A study by Atkeson and Ohanian (2001) showed that a random walk forecast outperforms a Phillips curve-based inflation forecast from 1984 onwards.
Okay, on to the meat of the paper:


As the figure shows, today's 5.25% funds rate is slightly above the lower bound of the Taylor-type rule prediction, in contrast to the 2002-2004 period, when the funds rate was well below the lower bound. Still, the current stance of policy could be tightened by more than 100 basis points without exceeding the upper bound.

The implication is that should this opinion count in future Fed rate decisions next year, the Fed is going to be comfortable holding pat at 5.25% until current inflation moderates. The trend since 2003, after a couple of years of very accommodative short rates, is still up in spite of the obvious signs of a slowing economy.

This is consistent with our expectation that the Fed will stay on the tightening path until it sees the whites of the bond trader's eyes, and the back-sides of equity investors.

12-22-06, 09:53 PM
Great piece. Looks like the Bernanke wants to try to bring this market down and defend the dollar (at least, slowing the decline).

I wonder if he realizes that M3 (and more exotic) money growth is undermining these goals. Interest rates now predominantly control only global basis point arbitrage opportunities, and indirectly, exchange rates -- not so much inflation.