Matt Nolan

Why we have to be careful equating CPI growth to inflation

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We have previously mentioned how important it is to interpret CPI growth carefully. Inflation is the trend rate of growth in the “general price level”, and as a result there are other factors that get caught up in our attempts to measure inflation.

James Hamilton at Econbrowser pointed to a paper by Reis and Watson which points out just how essential this difference is in a “low inflation environment”. The money quote from the abstract for me:

We find that pure inflation accounts for 15-20% of the variability in inflation while our aggregate relative-price index accounts most of the rest.

The pure inflation mentioned above is the fundamental increase in the general price level we often complain about as economists. “Inflation” in this paper is growth in the private consumption expenditure deflator (which is similar to the CPI – except that the bundle of goods is not fixed).

Now we don’t want to try and prevent relative price shifts – as that is the whole purpose of the price signal. So understanding this distinction is important. Very interesting.

Update: I don’t think I was clear enough on where I think the value is here. The paper seems to indicate to me that movements in the CPI and PCE deflator are relatively poor indicators of the magnitude of any change in inflation. This is a very good point, and I love it that this paper was able to mince the data up and show this.

Update 2:  Paul Walker blogs on a pre-release of the paper here.  Paul concludes:

They found that once they controlled for relative price changes, the correlation between (pure) inflation and real activity is essentially zero

That is true.  But let us be clear here, this implies that there is no money illusion (which economists currently assume), and so all quantity issues stem from nominal rigidities in prices (which we have discussed).   As a result, even pure inflation is still costly, as nominal rigidities exist causing a mis-allocation of resources (since relative prices get messed up).

Another interesting conclusion in the paper is that the rigidities in the labour market aren’t as strong as we would expect.  If this is shown to be the case over time it would change my implicit view of the economy.  Man I wish I could do a study like this for the NZ economy 🙂

Matt Nolan

Why keep long rates low?

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Bank economists are saying that we should aim to keep “long-term” rates low – through the RBNZ committing to a future path of the OCR for the next 3-5 years at a low rate.

At first brush we could be cynical and say this appears to be in their interest – the OCR does determine their cost of borrowing from the RBNZ after all.  But I am not that cynical about the bank economists.  Ultimately when you look at their beliefs, the commitment to a low OCR makes sense.  They believe:

  • Growth and “capacity” will remain well below trend for the medium term.  Specifically – we will be below our “natural rate of output”.  This implies that we don’t have to worry about inflationary pressures (until we are heading back to the natural rate).
  • Short rates have already headed nearly as low as they can go – so they can’t be cut much further.
  • The RBNZ’s growth path is “too strong” – and so the market expects rates to begin rising in 2010.
  • If medium term rates are higher this provides a disincentive to investment – something that depresses near term activity further, thereby increasing the risk of some sort of “downward spiral” through unemployment.

So ultimately, the retail banks are saying that the RBNZ is too optimistic (as if they weren’t their implicit forecasts would commit a lower medium term set of rates).  I guess we will see what the RBNZ does on Thursday and find out if they agree …

Matt Nolan

From a negative OCR to negative interest rates …

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Earlier we discussed a negative OCR as a way to push us towards the “zero bound” on interest rates.

But Greg Mankiw has brought up an interesting point – what happens if we want negative interest rates?

Mankiw admits that we could have a lottery scheme where some currency gets knocked out of circulation randomly – making the return on currency negative. However, he comes up with an interesting point if we just wanted to lower interest rates through a negative OCR.

If reserves earned a negative return at the margin, banks would have more incentive to lend (which is the motivation for these proposals). But more lending might not be the outcome. Banks could instead discourage deposits by, for example, passing the reserve fee on to depositors. Deposits would then earn a negative return, which would give households an incentive to hold currency rather than bank deposits

If the return goes negative for banks they may just pass it on to households who will “horde currency”.

However, I have to ask – will household’s just hold currency as savings? Read more

Matt Nolan

Bernanke is not rejecting Friedman

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A Bloomberg article stated that Bernanke is rejecting Friedman and following Keynes by printing money in the current environment (ht The Big Picture). However, this is far from the case.

Friedman believed that in the short run monetary policy could be used for demand management, but in the long-run undisciplined monetary policy will lead to inflation. The key belief here was that the “velocity of money” changes in the short run but is a constant over the long run. Friedman did not like the idea of using “fiscal policy” to manage demand – which is what Keynes proposed in the general theory.

Now, Bernanke doesn’t control fiscal policy – so I don’t think he is siding with Keynes. Further, Friedman blamed the GD on monetary policy being too contractionary – as even though the stock of money rose, the sharp fall in the velocity of money meant that the money supply contracted.

This is the logic Bernanke is using when introducing “credit easing”. Furthermore, in order to avoid the long run inflation problem he has set it up so a lot of the expansionary monetary policy will unwind (although he has committed to low interest rates in the future in order to keep inflation expectations positive).

As a result, I see his actions as completely consistent with Friedman – and I think the article is misleading.

Matt Nolan

Consumer prices – not asset prices

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Earlier I mentioned a piece by Steven Gjerstand and Vernon Smith that was a bit harsh on monetarism – as it ignored that the monetarist explanation and a economic readjustment explanation could be complements instead of substitutes.

Now Barry Ritholtz points out another interesting point from the piece – their discussion of the fact that house price growth was effectively taken out of the CPI.  The money quote is:

If home-ownership costs were included in the CPI, inflation would have been 6.2% instead of 3.3%. With nominal interest rates around 6% and inflation around 6%, the real interest rate was near zero, so household borrowing took off.

Let’s discuss.
Read more

Matt Nolan

Bleg: A negative OCR – how?

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I like the idea of being able to keep cutting the OCR – even once it hits zero.  It doesn’t mean that market rates will be negative, that doesn’t make any sense – but it does mean that monetary policy can push banks to lower reserves and increase the amount of money in circulation.  This is useful if we think we are facing deflation and the OCR has already hit zero.

However, how would we make it work?  If we only said reserves were reserves when they are held by a central bank, there would be no (or little) incentive for retail banks to hold reserves in this fashion when there is a penatly interest rate.  But they could just “hide money under the pillow”.

As a result, any definition of reserves in this case needs to include money hidden under banks collective pillows.

Furthermore, we need to be careful about what we do class as reserves on the other side.  If we class bonds as reserves we are only letting banks either lend or take a penalty – if lending prospects are bad then the RBNZ would just be taking money off the bank, not so much of a good move in the face of the current credit crisis.  If banks buy bonds it is still “stimulatory” – so that is something we want to leave there.

So how do we capture non-active reserves?  Does the RBNZ have enough information to do this?  Does it have the right to do this?  I would love some advice.