New SUERF Policy Brief with Mai Hakamada

 

Mai Hakamada (IMF) and I have a new SUERF Policy Brief on Inflation Shocks and Policy Delay: What are the Consequences of Falling Behind the Curve, available at https://www.suerf.org/publications/suerf-policy-notes-and-briefs/inflation-shocks-and-policy-delay-what-are-the-consequences-of-falling-behind-the-curve/.

Central banks in major industrialized economies were slow to react to the surge in inflation that began in early 2021 and have since faced difficulty taming persistent inflation. We evaluate the consequences of such a delay in responding to a temporary but persistent positive shock to inflation. Policy delay worsens inflation outcomes but can mitigate or even reverse the output decline that occurs when policy responds without delay; consequently, delay can make a recession less likely. Using a measure of loss that incorporates a “balanced-approach” to weighing fluctuations in inflation and the output gap, our research finds that loss is monotonically increasing in the length of the delay. Loss is reduced if policy, when it does react, does so more aggressively. The costs of a short delay can be eliminated by adopting a less inertial and more aggressive response to inflation.  

The policy brief summarizes the results from our March 2024 IMF Working Paper No. WP/24/42, available at https://www.imf.org/en/Publications/WP/Issues/2024/03/01/The-Consequences-of-Falling-Behind-the-Curve-Inflation-Shocks-and-Policy-Delays-Under-545507.

Taking responsibility for inflation

 

In “What we must still learn about the great inflation disaster” (April 28, 2024), Martin Wolf is correct in arguing that the Bernanke Report on the Bank of England’s forecasting performance was too narrowly focused. Shocks that are hard to forecast do happen, but, as Wolf asks, “… is it plausible that the fiscal and monetary policies that drove demand levels so strongly had nothing to do with the inflation?”

In 2021, statements by central bankers certainly gave the impression that inflation would simply fall away once shocks had passed, without making any explicit link to the monetary policy needed to ensure this occurs. The 1970s illustrated the dangers of treating inflation as if it were somehow unrelated to monetary policy. A surreal exchange captured in the transcript of the Fed’s policymaking committee meeting on September 9, 1978 is revealing. Lawrence K. Ross, President of the St. Louis Federal Reserve Bank, expressed exasperation as inflation rose towards 8 percent, said “I’m not trying to be critical, but is our monetary policy responsibility such that we should maybe discuss whether we’re satisfied to see the economy drift into an 8 percent inflation rate? And if not, are there things we can do to affect this? …Are we in any way masters of what happens, or are we merely observers on the sidelines? I’m lost...” To which Fed Chair G. William Miller drew upon the U.S. Constitution’s 5^th Amendment protection against self-incrimination in responding “I take the fifth.”

One would hope that no central banker today would fail to connect inflation developments to monetary policy actions. Yet focusing on forecasting errors seems a convenient way for policymakers to shift blame for errors onto the Bank’s staff. If inflation targeting is to have teeth, it is the policymakers who should be held to account when the target is so grossly missed.

New paper on the consequences of policy delay

My recent paper with Mai Hakamada of the IMF on monetary policy in the face of inflation surges, "The consequences of falling behind the curve: Inflation shocks and policy delays under rational and behavioral expectations," has been issued as IMF Working Paper WP/24/42 and is available at https://www.imf.org/en/Publications/WP/Issues/2024/03/01/The-Consequences-of-Falling-Behind-the-Curve-Inflation-Shocks-and-Policy-Delays-Under-545507?cid=em-COM-123-47987

Abstract: Central banks in major industrialized economies were slow to react to the surge in inflation that began in early 2021. The proximate causes of this surge were the supply chain disruptions associated with the easing of COVID restrictions, fiscal policies designed to cushion the economic impact of COVID, and the impact on commodity prices and supply chains of the war in Ukraine. We investigate the consequences of policy delay in responding to inflation shocks. First, using a simple three-period model, we show how policy delay worsens inflation outcomes, but can mitigate or even reverse the output decline that occurs when policy responds without delay. Then, using a calibrated new Keynesian framework and two measures of loss that incorporate a “balancedapproach” to weigh inflation and the output gap, we find that loss is monotonically increasing in the length of the delay. Loss is reduced if policy, when it does react, is more aggressive. To investigate whether these results are sensitive to the assumption of rational expectations, we consider cognitive discounting as an alternative assumption about expectations. With cognitive discounting, forward guidance is less powerful and results in a reduction in the costs of delay. Under either assumption about expectations, the costs of a short delay can be eliminated by adopting a less inertial policy rule and a more aggressive response to inflation. JEL: E31, E51, E52, E58, E61, Keywords: monetary policy; inflation; policy delay; behavioral expectations; falling behind the curve