Federal Reserve And Inflation Targeting - First Do No Harm

By: Paul Kasriel | Fri, May 5, 2006
Print Email

Appreciating that consumer price inflation is a monetary phenomenon and that the lags between policy actions and the manifestation of consumer price inflation are long (and perhaps variable), there is a better way for the Fed to attain its goal of inflation containment without contributing to the amplitude of business cycles. That consumer price inflation is a monetary phenomenon is a tautology. In a pure barter economy, there could not be general price-level increases because there is no general price level or numeraire. There could only be changes in relative prices. That there are long policy lags involved in the generation of consumer price inflation is suggested in the chart below. Plotted in the chart are the year-overyear percent changes in annual averages of the actual Personal Consumption Expenditure price index vs. forecasted changes. The forecast is based on year-over-year M2 money supply growth lagged three years, a constant term and a correction for serial correlation. The adjusted R-squared for this regression is 0.76. Different lags of M2 growth were tried, but the threeyear lag produced the best statistical results. Although the model's forecast missed the magnitudes of the twin spikes in consumer price inflation in 1974-75 and 1979-81 brought about by geopolitically-motivated interruptions in the supply of crude oil, the model did capture cyclical trend movements. Based on past money supply growth, the model is now forecasting a moderation in consumer price inflation through 2008. Perhaps the largely demand-side-motivated current spike in crude oil prices will yield a spike in consumer price inflation this year or next that the model is not forecasting. Perhaps fortuitously the monetary forces already in place (a slowdown in M2 growth) will mute the impact of the current spike in oil prices on consumer price inflation more than in times of prior oil-price spikes.

Personal Consumption Expenditure Price Index: Actual vs. Forecast*
(year-over-year percent change in annual average)

The takeaway from this inflation model is that the lags between money supply growth and consumer price inflation are long. Other models suggest that the lags between monetary policy actions and real economic activity are much shorter. So, by trying to fine-tune real economic activity in the short-run, the Fed could be setting in motion inflationary impulses that do not appear for years to come. This is what results in boom-bust cycles. The Fed "fights" recessionary forces, which unleashes future inflationary forces. Then the Fed trains its weapons on inflation, which results in recessions. If, as I suggested in a previous commentary (http://web-xp2a-pws.ntrs.com/content//media/attachment/data/econ_research/0603/ document/ec033006.pdf), the Fed were to target and achieve some steady rate of growth in the credit it creates, the amplitude of real economic cycles and price cycles - cycles of both consumer prices and asset prices - would be damped. This is not to say that cycles would be eliminated. It is to say that the amplitude of cycles would be less. A guiding principle of monetary policy should be the same as medical policy -- first do no harm.



Paul Kasriel

Author: Paul Kasriel

Paul L. Kasriel
Director of Economic Research
The Northern Trust Company
Economic Research Department
Positive Economic Commentary
"The economics of what is, rather than what you might like it to be."
50 South LaSalle Street, Chicago, Illinois 60675

Paul Kasriel

Paul joined the economic research unit of The Northern Trust Company in 1986 as Vice President and Economist, being named Senior Vice President and Director of Economic Research in 2000. His economic and interest rate forecasts are used both internally and by clients. The accuracy of the Economic Research Department's forecasts has consistently been highly-ranked in the Blue Chip survey of about 50 forecasters over the years. To that point, Paul received the prestigious 2006 Lawrence R. Klein Award for having the most accurate economic forecast among the Blue Chip survey participants for the years 2002 through 2005. The accuracy of Paul's 2008 economic forecast was ranked in the top five of The Wall Street Journal survey panel of economists. In January 2009, The Wall Street Journal and Forbes cited Paul as one of the few who identified early on the formation of the housing bubble and foresaw the economic and financial market havoc that would ensue after the bubble inevitably burst. Through written commentaries containing his straightforward and often nonconsensus analysis of economic and financial market issues, Paul has developed a loyal following in the financial community. The Northern's economic website was listed as one of the top ten most interesting by The Wall Street Journal. Paul is the co-author of a book entitled Seven Indicators That Move Markets.

Paul began his career as a research economist at the Federal Reserve Bank of Chicago. He has taught courses in finance at the DePaul University Kellstadt Graduate School of Business and at the Northwestern University Kellogg Graduate School of Management. Paul serves on the Economic Advisory Committee of the American Bankers Association.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The information herein is based on sources which The Northern Trust Company believes to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.

Copyright © 2005-2012 The Northern Trust Company

All Images, XHTML Renderings, and Source Code Copyright © Safehaven.com