Understanding inflation: lessons from my central banking career; the main lesson is that inflation is still a mystery

Business Economics, Jan, 2003 by Harvey Rosenblum

Economic theory--much less modeling based on historical data--has a difficult time keeping up with structural change in the contemporary economy. Anecdotal evidence and a feel for the economy based on experience are likely to be as important as theory-based modeling in making real-time policy decisions on the control of inflation and the stability of the economy. Many of the phenomena to be understood are microeconomic in nature. While much has been learned about effective stabilization policy over the past forty years, economists still have a long way to go before inflation can be understood and managed.

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The theme of NABE's 2002 annual meeting was "Understanding Cycles and Shocks." In light of what's happened to the economy, to NABE, and to its membership since our 2001 annual meeting at the World Trade Center in New York ended prematurely last September 11, I can think of no better theme for the annual meeting.

Economic policymakers responded quickly to the September 11 terrorist attacks. The Federal Reserve remained open for business and provided massive liquidity to the financial system to keep it running. Monetary stimulus was boosted through four additional reductions in the Federal funds rate target, bringing it to 1.75 percent on December 11, 2001, the lowest rate in four decades. As spending on the military and homeland security were added to other federal government spending, deficits ballooned and fiscal policy turned quite expansionary as well. Both monetary and fiscal policy rolled into high gear simultaneously, for the first time since the 1970S. We know how badly the 1970s policy mix worked out for the economy. As I speak, many of my colleagues in the economics profession are forecasting rising inflation. Others believe, however, that easy monetary and fiscal policies are barely offsetting the shortfall in demand.

What will happen to inflation? NABE surveys conducted throughout 2001 and 2002 suggest inflation will remain quiescent during 2003. Beyond that time frame, the outcome is a matter of open debate. In spite of the fact that inflation is such an important macroeconomic variable, I have come to the conclusion that economists don't fully understand the subject and have tried to oversimplify what turns out to be an extremely complex phenomenon.

My career as an economist began in August 1970 when I joined the Chicago Fed. Let me summarize what I've learned since 1970 about inflation and the processes that generate it.

* The Phillips Curve is not a reliable relationship. As soon as you (re)gain faith in it, the curve will shift and break your heart.

* Strict monetarist ideology no longer works in the modern-day financial system. Money is difficult to define, its growth even harder to control, and its relationship to economic activity often uncertain.

* Inflation is an evolving and very complex phenomenon that embodies a combination of macro and microeconomic forces. The economics profession has not fully appreciated the microeconomic factors.

* When the anecdotes and economic data do not corroborate one another, one of them is wrong. More often than not, it's the data. When the anecdotes and the data are in concordance, but the economic models suggest a different outcome, it's time for a new model. When the Fed's Beige Book respondents say they have no pricing power and the inflation statistics are drifting lower, we should seek to find the missing variables in models that forecast rising inflation.

* Macroeconomic models do not deal well with a changing economic structure, let alone paradigm shifts. Policymakers must make decisions in real time and cannot wait for the parameters in their economic models to catch up and stabilize. When in doubt, policymakers should pay greater attention to the anecdotes, especially large volumes of systematically gathered anecdotes like the ones the Fed analyzes regularly from the Beige Book.

* Last, the inflation experience of the 1970s is an aberration. It

was a combination of bad policy and bad shocks played out against a backdrop of bad institutions--monopoly pricing power for business and labor, increasing regulations, and complacency.

Confessions of a Monetarist

I was hired by the Chicago Fed in 1970 to work on micro-banking issues. I was happy to take the job because I thought I would be able to put my other expertise, monetary economics, to good use at the Fed. Armed with the monetarist teachings of Professor Robert E. Weintraub, I sought to educate my colleagues on a few simple principles. Namely, the Fed could expand or contract its balance sheet as needed to control the monetary base and in the process, exercise effective control over the money stock. By smoothing and slowing down the growth of money, the Fed would be able to reduce the rate of inflation, which had been trending up the prior few years. My ideas were not appreciated and were ignored. The St. Louis Fed had advocated a similar plan for several years, but the Federal Reserve System stuck to its operating plan, which sought to smooth fluctuations in short-term interest rates at the expense of influencing the rate of monetary growth. Inflation drifted up throughout the 1970s.