Sunday, June 14, 2009

Flashback: the inflation worries of summer 2008

I just came across an old post of mine from 2008, where I angrily defended the core CPI against critics who claimed that it hid inflation that would soon roil the economy.

An obvious thought comes to mind: if these people actually influenced our monetary policy, and the Fed had raised rates in September 2008 in response to "worrying" CPI increases (which were really just in food and oil), where would we be now? My guess is that in such a world, 10% unemployment would seem like a rosy vision of recovery.

Nearly everyone failed to anticipate the depth of our financial crisis, or address systemic risks before they blasted their way into the popular consciousness. But compared to the idiocy of mid-2008 inflation hawks, these failures seem minor. If you thought that the summer of 2008 was a good time for the Fed to tighten the money supply, you should be permanently disqualified from offering economic commentary.

3 comments:

John Farragut said...

People don't like reading bloggers who come off as jerks; at least I don't. Macro is hard, just take it from Alan Greenspan: "If we are right 60 percent of the time in forecasting, we’re doing exceptionally well. That means we are wrong 40 percent of the time."

You have predicted inflation will not be a problem as a result of the government's response during the current recession. Will you write a post about how much of an "idiot" you are, if it turns out you were mistaken? All I'm trying to say is that you make yourself look bad when you get all ad hominem.

Anyway... My view (probably this should go in your other post, but I am already here) is that inflation will be a problem in the future, and possibly a large one, but because of fiscal rather than monetary policy.

The U.S. will suffer if the debt keeps growing at its current rate, especially if China's growth slows and the demand for our bond drops significantly. The government's forecasts about growth are too high; future deficits will be higher than they claim. As I see it, there are three main options, though perhaps I'm leaving things out, for dealing with the problem:

1. Raise taxes sharply. This is unlikely for political reasons, though they will likely increase moderately.
2. Experience significant growth. I view this as also unlikely, though more likely than optiion 1.
3. Monetize the debt. I unfortunately think this is the likeliest outcome. It is politically easiest and "doesn't cost anyone" anything like raising taxes does. Of course, that is not true at all, but the costs are least obvious to people.

The one thing I admit I need to think more about is the difference between a relatively high federal deficit versus a relatively high federal debt. Obviously the two concepts are related, but the distinction is very important. I admittedly am much weaker in macro than I am in micro; can you help me with this question?

Matt Rognlie said...

Fair enough, but I think that there are "levels of wrongness," and that there's a certain point at which it's fair (albeit a little shrill) to characterize a belief as "idiocy." I don't think that inflation is a serious threat right now, but there are some smart people making decent arguments about why it is -- and while my post stated in no uncertain terms that an increase in the monetary base doesn't make inflation inevitable (or even probable), I'm not absolutist on the point that inflation cannot possibly be a problem. This is an issue where reasonable people can disagree.

On the other hand, declaring that the Fed should tighten policy when unemployment is already skyrocketing and most observers believe a recession is imminent, merely because you've eyeballed the CPI and think that inflation is building up (despite the fact that core inflation is almost zero, and a severe recession has deflationary tendencies)... well, that's pretty bad. Deciding whether or not to call this "idiocy" is more a question of tone than substance, and maybe my substance would be more effective if I dropped the tone.

Matt Rognlie said...

On your points, I think it's possible that we'll follow a third path: some spending cuts and tax increases, enough to stabilize the debt at perhaps 100% of GDP. This is a pretty high load, but we can still muddle through and keep it from becoming worse (and ultimately improve it a little). If economic growth is 2.5% a year, seignorage revenue is 0.5% a year, and the real interest rate on our debt is 3% a year, then if our budget is balanced excluding interest, the debt load will stay constant if it's 100% of GDP.

In fact, these figures are all a little conservative. If the real interest rate is 2% (roughly what we pay on long-term debt right now, while short-term is much cheaper) and economic growth is 3% instead, then we can run an annual deficit of 1% of GDP without any further deterioration. This still a lot less than what we pay today, and some combination of tax increases and spending discipline will be necessary, but I'm not sure if it's quite as extreme as your scenarios make it seem.

Regarding your question about deficits and debt, I think (and hopefully the analysis above illustrates) that the debt is a far more important figure, and it should be interpreted in relation to our economy's ability to pay it, by examining it as a fraction of GDP. The deficit is important insofar as it determines the rate of change of our debt, and that it may overwhelm the capacity of bond markets to adjust if it's really extreme. (This seems unlikely, though, because deficits tend to undergo the biggest spikes during recessions, when there is excess saving in the economy and plenty of demand for low-risk debt.)