Tuesday, May 19, 2015

Feldstein on inflation

Martin Feldstein has an interesting Op-Ed in the Wall Street Journal, "Why the U.S. Underestimates Growth."

The basic idea is that inflation may be overstated, because it doesn't do a good job of handling new products. As a result, real output growth may be a bit stronger than measured.  Marty runs through a lot of sensible conclusions.

He doesn't talk about monetary policy, but that's interesting too. So what if inflation really is (say) 3% lower than we think it is, and therefore real output growth is 3% larger than it really is?

That would mean we are a lot closer to "normal" of course.

It would mean that we really have 0% nominal interest rates, 1.5% deflation rather than 1.5% inflation; +1.5% real rates rather than -1.5% real rates. That is about the ideal monetary policy. Flat nominal wages, so we don't have wage stickiness problems, slight deflation matching productivity increases and a positive but low real rate of interest. We live the Friedman optimal quantity of money. In addition, it means no inflationary distortions and fewer intertemporal distortions in the tax code -- no taxing interest.

The labor market is pretty much back to normal except for the labor force participation rate. The main sign of weakness is real output growth, and Marty suggests that might not even be there.

How should the Fed react? News that real output growth is stronger than the Fed thinks would be an argument to raise rates. News that inflation is weaker than the Fed thinks is an argument to lower rates. At conventional Taylor-rule parameters of 1.5 times inflation plus 0.5 times output gap, news that inflation is 1% lower and output is 1% higher means the lowering effect wins. So, in fact this is an argument to keep rates where they are and to continue basking in the Friedman optimal quantity of money for a while.

In fact, this strikes me as the main conclusion. As Marty points out, if real growth is stronger than we think, that doesn't mean it couldn't be stronger still. If real wages are really rising, that doesn't mean they couldn't be rising more. Weak labor force participation and total factor productivity are not much influenced by inflation measures.


  1. John,

    At conventional Taylor-rule parameters of 1.5 times inflation plus 0.5 times output gap, news that inflation is 1% lower and output is 1% higher changes nothing.

    The reason is that if output is 1% higher, that must also mean that potential output is 1% higher as well. You can't close the real output gap by changing your definition of inflation no matter how much Feldstein wants to try.

  2. The Fed is obsessing with an (inaccurate) IT that is suffocating the economy!

    Yes, absolutely, we should cut taxes on productive behavior (FICA tax cuts come to mind first, btw) and the Fed should blow the roof off.

    I suggest a FICA tax holiday, offset by the Fed buying $80 billion in bonds month and placing them into the Social Security-Medicare trust funds.

    Of course, taxes and regs should be the lightest possible, every economist agrees with that, But what Feldstein is really saying is that the Fed has been asphyxiating the economy for no reason--it should really be shooting for 4% inflation on the CPI, as measured.

    BTW, the fact we are in zero inflation now may be why we are seeing such huge bulges in cash in circulation, People are saving in the form of cash. This has dangerous unintended consequences. Once people have a lot of cash (as in $4,200 for every US resident), they start spending in cash--and dodging the tax man.

    Soon, a bifurcated economy emerges, one taxed and aboveground, and another grey market, cheaper and untaxed.

    Guess where that heads?

    Greece? Bananaland?

  3. Jose Romeu RobazziMay 20, 2015 at 8:48 AM

    Prof. Cochrane
    It is possible that Mr. Feldestein is right, and we underestimate growth. But theoretically the opposite might true too, I can think of a number of situations where inflation is underestimated, like for example, when one buys clothes that are made with inferior fiber, but cost the same, or when one goes to a restaurant, and the amounr of food on a certain plate has been reduced (not noticeably) but costs the same, etc. Thinking only on the difficult task of estimating price level changes, what do you believe is more probable: our current methodologies overestimate inflation and underestimate growth or the opposite, they underestimate inflation and overestimate growth?

    1. Or the fact that appliances that used to last 20 years now can't be counted on to last 5 years.

  4. If FED is underestimating (or, as previous poster says, overestimating) growth, isn't that systematic problem lasting decades (at least)? And that would mean that all the measures FED has been undertaking are just as optimal (or wrong) if growth is really underestimated as they would be if growth is perfectly assessed. If problem is systematic, that would mean that decades-long theories and practice also have the same systematic error.

    1. Yep, it would also mean that the calibrating coefficients that John is used for the Taylor rule are likely wrong as well, since those coefficients are created using "incorrectly measured" inflation and real growth data from a prior time.

  5. Participation in the work force and inflation are not as much related as say wages and inflation. I do think the fed is not very good at accurately measuring inflation because there are lags and distribution effects in monetary policy. This was highly expressed my Friedman himself.

  6. No one questions that the estimates of nominal GDP growth is reasonably accurate. So if inflation is overstated real GDP is understated. But I have real problems with the argument that new products cause inflation to be significantly overstated. Almost by definition new products are purchased by a very few early adapters and that if you had good detailed data it would not make a significant difference in the aggregate data. I was an early adapter of personal computers in the 1980s and remember how prices fell so rapidly. But how many people actually bought personal computers in the mid-1980s, probably a few thousand and it certainly was not enough to cause nominal and real GDP to be significantly understated.
    I just find it hard to accept that new products are that important to the economy before the BLS & BEA incorporates them into the inflation data

    1. Jose Romeu RobazziMay 22, 2015 at 7:23 AM

      I agree with this view. NGDP is a robust concept, errors in estimating it can be mitigated by careful sampling. RGDP and inflation, on the other hand, depend on the methodology adopted, no matter how thouhgt out they are ...NGDP is a better "thermometer" for whatever policy people want do adopt


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