Bank of Japan IMES Special Trialogue

To mark the 40th anniversary of the Institute for Monetary and Economic Studies (IMES) at the Bank of Japan, I participated in a discussion with Athanasios Orphanides (my fellow Honorary Adviser to the IMES), and Deputy Governor Masazumi Wakatabe that touched on three questions: 1) Interactions between central banks and the academic community; 2) Art versus science in the conduct of monetary policy; and 3) The role of central bank research for communications.

The first of these discussions is now available at https://www.imes.boj.or.jp/index.html?lang=en&page=7&id=#07&src=.\en\newsletter\nl202302E1_r.html. In it, Athanasios and I review the evolving relationship between academics and central bank economics, focusing on the U.S. experience. In my comments, I noted how much this relationship has changed since I began my professional career almost 50 years ago. In the 1970 and 80s, standard models stressed that policy surprises were what mattered for the real economy. Any systematic, predictable monetary policy was irrelevant for business cycle behavior. These models were not well posed to offer guidance on how systematic monetary policy could contribute to stabilizing the real economy. That changed with the adoption of the new Keynesian model, which provided a common framework for academic and central bank researchers to contribute to policy-relevant issues.

In his comments, Athanasios stressed that “…research is essential for understanding what has gone wrong in the past. Sometimes it takes decades to understand why some major economic disasters happened and research is what guides us to improve policy.” He used the Great Depression as an example, noting that it took two decades after the publication of Milton Friedman and Anna Schwartz’s Monetary History of the United States before it was recognized in the profession as the best explanation and understanding of what had gone wrong with Federal Reserve policy during the Great Depression.

Incidentally, Milton Friedman and James Tobin were the first two Honorary Advisers to the IMES. I stepped down as an Honorary Adviser in December; Markus Brunnermeier of Princeton University took on the role in January. A complete list of all the Honorary Advisers since 1982 can be found at the Institute's web site at https://www.imes.boj.or.jp/en_about.html

Confusing the price level and the inflation rate

Isn't it annoying when the price level and the rate of inflation are confused? Or when bringing down the inflation rate is confused with reducing the price level? See my recent (Feb. 20, 2023) letter in the FT: https://www.ft.com/content/e7fff27b-0c10-47a7-b9a0-d6470b80c68c. (Subscription may be needed.)

In memory of Ben McCallum

Bennett T. McCallum died December 28, 2022. Ben was a major contributor to macro and monetary economics, with important publications spanning 40 years. While his work touched on many topics, his papers on equilibrium determinacy in rational expectations models, monetary policy, interest rate rules, and the importance of robustness in designing policy rules were, I think, his most important. He offered insights into the theoretical implications of general equilibrium monetary models under rational expectations as well as practical guidance to the evaluation of policy rules.

My first interaction with Ben was when he was a discussant of the paper I presented at the 1982 Federal Reserve Bank of Kansas City Jackson Hole Symposium. Far from filling the large meeting room just off the Jackson Lake Lodge's lobby as it does now, in 1982 the whole event was held downstairs in modest room that felt like a basement.

It is interesting to look back at the 1982 Symposium and see what has changed and what has remained the same in terms of the featured topics. On the first day, Alan Blinder presented "Issues in the Coordination of Monetary and Fiscal Policy," and John Taylor presented "The Role of Expectations in the Choice of Monetary Policy," topics still discussed today.  The next day I offered a paper on "The Effects of Alternative Operating Procedures on Economic and Financial Relationships,"  Ed Kane presented "Selecting Monetary Targets in a Changing Financial Environment," and Ben Friedman presented "Using a Credit Aggregate Target to Implement Monetary Policy in the Financial Environment of the Future.” The second day papers reflected the debates of the time over instruments and targets for monetary policy. Nowadays it is taken for granted that central banks employ a short-term interest rate as their policy instrument and that targets should be for goals such as inflation, not for alternative definitions of reserves or monetary aggregates.

In looking back over Ben's discussion of my 1982 paper, I was struck by his concluding comments: "...recommending the use of equilibrium models is not the same as asserting that the behavior of the economy is well-described by flexible-price equilibrium models. As Taylor's (1982) paper for the conference points out, these models are difficult to reconcile with the data. What is needed is an extended equilibrium analysis that explains the existence and nature of nominal contracts and thus predicts how they will respond to changes in policy…The virtue of the equilibrium-analysis program is that it provides a particular form of analytical discipline, i.e., it encourages one to think carefully about the behavior of individual agents and about the way in which the actions of many such agents interact. This discipline is valuable...."

Recall that 1982 was the year Kydland and Prescott published "Time to build and aggregate fluctuations,” (Econometrica, 50:1345-1370), providing the foundation for real business cycle analysis based on equilibrium modeling approaches. Ben stressed that the use of equilibrium models did not preclude introducing nominal rigidities that both facilitated the study of monetary policy rules and helped to fit business cycle data. Since the early 1980s, economists in the new Keynesian tradition have made great strides in extending our understanding of the role of nominal rigidities. However, the profession has been less successful in addressing Ben’s call for explaining the existence of such rigidities.

Here is a very short and selective set of some of Ben’s important papers; the titles give a good sense of some of the topics he worked on:

McCallum, B.T. 1981. “Price Level Determinacy with an Interest Rate Policy Rule and Rational Expectations.”  Journal of Monetary Economics 8:319-329.

McCallum, B T. 1983. “On Non-Uniqueness in Rational Expectations Models: An Attempt at Perspective.” Journal of Monetary Economics 11 (2): 139–68.

McCallum, B.T. 1986. “Some Issues Concerning Interest Rate Pegging, Price Level Determinacy, and the Real Bills Doctrine.” Journal of Monetary Economics 17 (1): 135–60.

McCallum, B.T. 1988. “Robustness Properties of a Rule for Monetary Policy.” Carnegie-Rochester Conference Series on Public Policy 29: 173–204.

McCallum, B.T. 1999. “Issues in the Design of Monetary Policy Rules.” In Handbook of Macroeconomics, edited by J Taylor and M Woodford, 1483–1530. Vol. 1C, Amsterdam: Elsevier North-Holland.

Inflation surges in perspective

 

This week’s FOMC statement and Chair Powell’s press conference rightly stressed the progress that has been made in controlling inflation, and the U.S. does seems to be past the peak of the inflation surge of 2021-2022. Powell was correct, however, in stating that it is too early to claim victory. To offer some perspective, this post looks at other inflation surges over the past 50 years.

Figure 1 shows U.S. inflation over the period 1960 to 2022 as measured by the percent year-over-year change in three different price indices: the consumer price index (CPI), the personal consumption index, the personal consumption index (PCEPI) less food and energy prices (PCEPILFE), and a measure of the prices of sticky goods and services prices constructed by the Federal Reserve Rank of Atlanta (it also excludes food and energy prices). All data is obtained from the St. Louis Federal Reserve Bank’s FRED database. https://fred.stlouisfed.org/.

The figure suggests four inflation-surge episodes, three of which occurred between the late 1960s and the early 1980s, a period that encompasses the Great Inflation. The first two surges were quickly followed by another and larger upward surge in inflation. After the third surge, which peaked in June 1980, CPI and Sticky CPI inflation started rising again, reaching a second peak in Sept. 1981, but thereafter all four inflation measures continued to fall as the economy entered the period of the Great Moderation.  

The fourth surge in inflation that stands out is the one in 2021-2022. 

The second figure isolates the four inflation surges. The mid-1970s and late 1970s cases (in the upper right and lower left panels) are the most interesting from today's perspective. Both were associate with oil shocks. In both cases, CPI inflation, which includes food and energy prices, dropped relatively quickly. In the case shown in the upper right panel, inflation fell, but not back to its starting level, before rising again, leading into the inflation surge seen in the lower left panel. 

The question now is whether the current inflation surge, seen in the lower right, will follow the pattern of the early 1980s, with inflation eventually stabilizing around a low level, or whether it might be 1976 again, with only a temporary decline, followed by an uptick in inflation. And even if there is no uptick, will it decline to rates similar to when the surge started, as with the first surge in 1970 (upper left panel), stabilize at the Fed's 2% target, or halt at a higher rate, perhaps around 4% as some have advocated?  

In his opening remarks at the press conference following the FOMC meeting February 2, 2023, Chair Powell stated that, in the fight to bring inflation down, the Fed has "...covered a lot of ground, and the full effects of our rapid tightening so far are yet to be felt. Even so, we have more work to do. Price stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy." Inflation over the next year will depend critically on the credibility of that statement.

As a sidenote, the Sticky Price CPI index doesn't look very sticky. Despite the fact it is meant to measure the prices of good and services that do not change frequently, and excludes food and energy prices, it is only in the recent episode that it lagged appreciably behind the other measures as inflation initially rose. It also has not yet peaked (as of January 2023).  

Role of money at the lower bound

Roberto Billi, Ulf Söderström and I just reviewed the proofs for our forthcoming JMCB paper, "The role of money in monetary policy at the lower bound."  In the paper, we reconsider the merits of strict money growth targeting (MGT) relative to conventional inflation targeting (IT) and to price level targeting (PLT). We evaluate these policies in terms of social welfare through the lens of a new Keynesian model and accounting for a zero lower bound (ZLB) constraint on the nominal interest rate. Although MGT makes monetary policy vulnerable to money demand shocks, MGT contributes to achieving price level stationarity and significantly reduces the incidence and severity of the ZLB relative to both IT and PLT. Furthermore, MGT lessens the need for fiscal expansions to supplement monetary policy in fighting recessions.

While the framework we employ is a stylized, but common, New Keynesian model, our findings suggest a productive avenue for future research will be to explore the re-introduction of money into monetary policy in a wider class of model environments.

Here is a link to the current draft of the paper. The final JMCB version should be available soon.