When Jukka Savolainen wrote about it in the Wall Street Journal I couldn't quite believe it, so I had to go look. Indeed, on the website of the American Sociological Association describing its 2024 annual meeting we have the official "theme" of the meeting
"..sociology as a form of liberatory praxis: an effort to not only understand structural inequities, but to intervene in socio-political struggles."
"To intervene." "Political struggles."
This post is from a set of comments I gave at the NBER Asset Pricing conference in early November at Stanford. Conference agenda here. My full slides here. There was video, but sadly I took too long to write this post and the NBER took down the conference video.
I was asked to comment on "Downward Nominal Rigidities and Bond Premia" by François Gourio and Phuong Ngo. It's a very nice clean paper, so all I could think to do as discussant is praise it, then move on to bigger issues. These are really comments about whole literatures, not about one paper. One can admire the play but complain about the game.
The paper implements a version of Bob Lucas' 1973 "International evidence" observation. Prices are less sticky in high inflation countries. The Phillips curve more vertical. Output is less affected by inflation. The Calvo fairy visits every night in Argentina. To Lucas, high inflation comes with variable inflation, so people understand that price changes are mostly aggregate not relative prices, and ignore them. Gourio and Ngo use a new-Keynesian model with downwardly sticky prices and wages to express the idea. When inflation is low, we're more often in the more-sticky regime. They use this idea in a model of bond risk premia. Times of low inflation lead to more correlation of inflation and output, and so a different correlation of nominal bond returns with the discount factor, and a different term premium.
I made two points, first about bond premiums and second about new-Keynesian models. Only the latter for this post.
This paper, like hundreds before it, adds a few ingredients on top of a standard textbook new-Keynesian model. But that textbook model has deep structural problems. There are known ways to fix the problems. Yet we continually build on the standard model, rather than incorporate known ways or find new ways to fix its underlying problems.
Problem 1: The sign is "wrong" or at least unconventional.
The Supreme Court is hearing a case with profound implications for the income tax. WSJ editorial here and good commentary from Ilya Shapiro here.
This issue is naturally contorted into legalisms: What the heck does "apportioned" mean? How is "income" defined legally? I won't wade into that. What are the economic issues? What's the right thing to do here, leaving aside legalisms?
Just in time for the holidays, the perfect stocking stuffer -- if you have really big stockings. 30% discount on Fiscal Theory of the Price Level until June 30 2024.
And Fiscal Theory makes the Economist's list of best books for 2023.
With President Milei's election in Argentina, dollarization is suddenly on the table. I'm for it. Here's why.
Cass Sunstein has a lovely New York Times essay that tries to give us back the word "Liberal." I hope it works.
Sunday Nov 19 6-7 PM I will be giving the "Association Lecture" at the Southern Economics Association conference in New Orleans. The topic naturally is "The Fiscal Theory of the Price Level." If you're curious, and will be at the conference, stop by. I now have a pretty good condensed talk about fiscal theory!
Last week I was honored to be moderator for a discussion with Greg Lukianoff and Rikki Schlott on their new book "Canceling the American Mind" at the Commonwealth Club of San Francisco. Link here, if the embed above doesn't work
Here are my questions. I shared them with Greg and Rickki ahead of time, so the actual questions are a bit shorter. But this may give you some interesting background, and I think they're good questions to ponder in general.
Mickey Levy's excellent WSJ oped leaves some thoughts.
Inflation has fallen, though I still suspect it may get stuck around 3-4%. But prices "are 18.9% higher than its [their] pre-pandemic level." And some important prices have risen even more. "Rental costs continue to rise in lagged response to the 46.1% surge in home prices." Those who are taking a victory lap about the end of inflation (the rate of change of prices) are befuddled by continuing consumer (and voter) anger.
Well, prices are not the same thing as inflation.
A lot of graphs look like this, including the Fed's "dot plot" projections of where interest rates will go, inflation forecasts, and longer term interest rate forecasts based on the yield curve (yields on 10 year bonds imply a forecast of one year bonds over the 10 year period.) Just change the labels.
David Leonhardt's pean to investment in the Sunday NY Times Magazine starts well:
A cross-country trip today typically takes more time than it did in the 1970s. The same is true of many trips within a region or a metropolitan area....Door to door, cross-country journeys often last 10 or even 12 hours.
A week ago Jay Bhattacharya gave a great talk at the weekly Stanford Classical Liberalism workshop. (Link in case the embed doesn't work.) He detailed the story of government+media Covid censorship, along with the dramatic injunction in the Missouri v. Biden case. The discovery in that case alone, detailing how the administration used the threat of arbitrary regulatory retaliation to get tech companies to censor covid information -- along with other matters, including the Hunter Biden laptop -- is astonishing. We now know what they did, no matter what judges say about its technical legality.
This is a draft oped. It didn't make it as events in Israel are now consuming attention. But sooner or later we need to elect a president and live with the results. I went light on the economics, but you can see the basic game theory of the analysis. It amplifies some comments I made on Goodfellows.
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If, as it appears, the election will come down to Trump vs. Biden, the US is headed for a constitutional crisis, and the social, and political chaos that implies. Like prisoners of the economists’ dilemma, there seems no easy way out.
Whichever wins, the others’ partisans will pronounce the president to be fundamentally illegitimate. In turn, Illegitimacy justifies and emboldens scorched-earth tactics, more norm-busting and institution-destruction.
Today, I'll add an entry to my occasional reviews of interesting academic papers. The paper: "Price Level and Inflation Dynamics in Heterogeneous Agent Economies," by Greg Kaplan, Georgios Nikolakoudis and Gianluca Violante.
One of the many reasons I am excited about this paper is that it unites fiscal theory of the price level with heterogeneous agent economics. And it shows how heterogeneity matters. There has been a lot of work on "heterogeneous agent new-Keynesian" models (HANK). This paper inaugurates heterogeneous agent fiscal theory models. Let's call them HAFT.
This post takes up from two previous posts (part 1; part 2), asking just what do we (we economists) really know about how interest rates affect inflation. Today, what does contemporary economic theory say?
As you may recall, the standard story says that the Fed raises interest rates; inflation (and expected inflation) don't immediately jump up, so real interest rates rise; with some lag, higher real interest rates push down employment and output (IS); with some more lag, the softer economy leads to lower prices and wages (Phillips curve). So higher interest rates lower future inflation, albeit with "long and variable lags."
Higher interest rates -> (lag) lower output, employment -> (lag) lower inflation.
In part 1, we saw that it's not easy to see that story in the data. In part 2, we saw that half a century of formal empirical work also leaves that conclusion on very shaky ground.
As they say at the University of Chicago, "Well, so much for the real world, how does it work in theory?" That is an important question. We never really believe things we don't have a theory for, and for good reason. So, today, let's look at what modern theory has to say about this question. And they are not unrelated questions. Theory has been trying to replicate this story for decades.
The answer: Modern (anything post 1972) theory really does not support this idea. The standard new-Keynesian model does not produce anything like the standard story. Models that modify that simple model to achieve something like result of the standard story do so with a long list of complex ingredients. The new ingredients are not just sufficient, they are (apparently) necessary to produce the desired dynamic pattern. Even these models do not implement the verbal logic above. If the pattern that high interest rates lower inflation over a few years is true, it is by a completely different mechanism than the story tells.
I conclude that we don't have a simple economic model that produces the standard belief. ("Simple" and "economic" are important qualifiers.)
The simple new-Keynesian model
(This post continues part 1 which just looked at the data. Part 3 on theory is here)
When the Fed raises interest rates, how does inflation respond? Are there "long and variable lags" to inflation and output?
There is a standard story: The Fed raises interest rates; inflation is sticky so real interest rates (interest rate - inflation) rise; higher real interest rates lower output and employment; the softer economy pushes inflation down. Each of these is a lagged effect. But despite 40 years of effort, theory struggles to substantiate that story (next post), it's had to see in the data (last post), and the empirical work is ephemeral -- this post.
The vector autoregression and related local projection are today the standard empirical tools to address how monetary policy affects the economy, and have been since Chris Sims' great work in the 1970s. (See Larry Christiano's review.)
I am losing faith in the method and results. We need to find new ways to learn about the effects of monetary policy. This post expands on some thoughts on this topic in "Expectations and the Neutrality of Interest Rates," several of my papers from the 1990s* and excellent recent reviews from Valerie Ramey and Emi Nakamura and Jón Steinsson, who eloquently summarize the hard identification and computation troubles of contemporary empirical work.
Maybe popular wisdom is right, and economics just has to catch up. Perhaps we will. But a popular belief that does not have solid scientific theory and empirical backing, despite a 40 year effort for models and data that will provide the desired answer, must be a bit less trustworthy than one that does have such foundations. Practical people should consider that the Fed may be less powerful than traditionally thought, and that its interest rate policy has different effects than commonly thought. Whether and under what conditions high interest rates lower inflation, whether they do so with long and variable but nonetheless predictable and exploitable lags, is much less certain than you think.
An a recent WSJ oped (which I will post here when 30 days have passed), I criticized the "supply shock" theory of our current inflation. Alan Blinder responds in WSJ letters
First, Mr. Cochrane claims, the supply-shock theory is about relative prices (that’s true), and that a rise in some relative price (e.g., energy) “can’t make the price of everything go up.” This is an old argument that monetarists started making a half-century ago, when the energy and food shocks struck. It has been debunked early and often. All that needs to happen is that when energy-related prices rise, many other prices, being sticky downward, don’t fall. That is what happened in the 1970s, 1980s and 2020s.
Second, Mr. Cochrane claims, the supply-shock theory “predicts that the price level, not the inflation rate, will return to where it came from—that any inflation should be followed by a period of deflation.” No. Not unless the prices of the goods afflicted by supply shocks return to the status quo ante and persistent inflation doesn’t creep into other prices. Neither has happened in this episode.
When economists disagree about fairly basic propositions, there must be an unstated assumption about which they disagree. If we figure out what it is, we can think more productively about who is right.
I think the answer here is simple: To Blinder there is no "nominal anchor." In my analysis, there is. This is a question about which one can honorably disagree. (WSJ opeds have a hard word limit, so I did not have room for nuance on this issue.)
(This post is an interlude between history and VARs)
Jesper Rangvid has a great blog post today on different inflation measures.
CPI and PCE core inflation (orange and gray) are how the US calculates inflation less food and energy, but including housing. We do an economically sophisticated measure that tries to measure the "cost of housing" by rents for those who rent, plus how much a homeowner pays by "renting" the house to him or herself. You can quickly come up with the plus and minus of that approach, especially for looking at month to month trends in inflation. Europe in the "HICP core" line doesn't even try and leaves owner occupied housing out altogether.
Jesper's point: if you measure inflation Europe's way, US inflation is already back to 2%. The Fed can hang out a "mission accomplished" banner. (Or, in my view, a "it went away before we really had to do anything serious about it" banner.) And, since he writes to a European audience, Europe has a long way to go.
A few deeper (and slightly grumpier) points:
Today I begin a three part series exploring interest rates and inflation. (Part 2 empirical work, Part 3 theory)
How does the Fed influence inflation? Is the recent easing of inflation due to Fed policy, or happening on its own? To what extent should we look just to the Fed to bring inflation under control going forward?
The standard story: The Fed raises the interest rate. Inflation is somewhat sticky. (Inflation is sticky. This is important later.) Thus the real interest rate also rises. The higher real interest rate softens the economy. And a softer economy slowly lowers inflation. The effect happens with "long and variables lags," so a higher interest rate today lowers inflation only a year or so from now.
interest rate -> (lag) softer economy -> (lag) inflation declines
This is a natural heir to the view Milton Friedman propounded in his 1968 AEA presidential address, updated with interest rates in place of money growth. A good recent example is Christina and David Romer's paper underlying her AEA presidential address, which concludes of current events that as a result of the Fed's recent interest-rate increases, "one would expect substantial negative impacts on real GDP and inflation in 2023 and 2024."
This story is passed around like well worn truth. However, we'll see that it's actually much less founded than you may think. Today, I'll look at simple facts. In my next post, I'll look at current empirical work, and we'll find that support for the standard view is much weaker than you might think. Then, I'll look at theory. We'll find that contemporary theory (i.e. for the last 30 years) is strained to come up with anything like the standard view.
(Updated to fix numbers.) Fitch is right to downgrade the US. Read the sober report. But there are a few other reasons, or emphasis they might have added.
Inflation is the economic equivalent of a partial default. The debt was sold under a 2% inflation target, and people expected that or less inflation. The government borrowed and printed $5 Trillion with no plan to pay it back, devaluing the outstanding debt as a result. Cumulative inflation so far means debt is repaid in dollars that are worth 10% less than if inflation had been* 2%. That's economically the same as a 10% haircut.
