I Continue To Fail To Understand Why The Federal Reserve's Read Of Optimal Monetary Policy Is So Different From Mine

by: Brad DeLong

Does you think this looks like an economy where inflation is on an upward trend and interest rates are too low for macroeconomic balance?

Personal Consumption Expenditures Chain type Price Index FRED St Louis Fed

Graph Personal Consumption Expenditures Excluding Food and Energy Chain Type Price Index FRED St Louis Fed

Mohamed El-Erian says, accurately, that the Federal Reserve is much more likely than not to increase interest rates in June or July:

Mohamed El-Erian: Federal Reserve Is Torn

"Moves in financial conditions as a whole are making [the Fed]... more confident about going forward [with interest-rate hikes,] and they were worried that the markets were underestimating the possibility of a rate hike this year and they wanted to do something about it... In the end, what's clear is a hike will definitely happen this year... If the Fed unambiguously signals that it will move, you will see a stronger dollar and that... will have consequences on other markets...

Olivier Blanchard (2016), [Blanchard, Cerutti, and Summers (2015)], Kiley (2015), IMF (2013), and Ball and Mazumder (2011) all tell us this about the Phillips Curve:

  • The best estimates of the Phillips Curve as it stood in the 1970s is that, back in the day, an unemployment rate 1% point less than the NAIRU maintained for 1.5 years would raise the inflation rate by 1% point, and that a 1% point increase in inflation would raise future expected inflation by 0.8% points.

  • The best estimates of the Phillips as it stands today is that, here and now, an unemployment rate 1% point less than the NAIRU maintained for 5 years would raise the inflation rate by 1% point, and that a 1% point increase in inflation would raise future expected inflation by 0.15% points.

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In only 6 of the last 36 months has the PCE core inflation rate exceeded 2.0%/year. I keep calling for someone to present me with any sort of optimal control exercise that leads to the conclusion that it is appropriate for the Federal Reserve to be raising interest rights right now.

Civilian Employment Population Ratio FRED St Louis Fed

I keep hearing nothing but crickets...

My worries are compounded by the fact that the Federal Reserve appears to be working with an outmoded and probably wrong model of how monetary policy affects the rest of the world under floating exchange rates. The standard open-economy flexible exchange rate models I was taught at the start of the 1980s said that contractionary monetary policy at home had an expansionary impact abroad: the dominant effect was to raise the value of the home currency, and thus, boost foreign countries' levels of aggregate demand through the exports channel. But Blanchard, Ostry, Ghosh, and Chamon (2015) argue, convincingly, that that is more likely than not to be wrong: when the Fed or any other sovereign reserve currency issuer with exorbitant privilege raises dollar interest rates, that drains risk-bearing capacity out of the rest of the world economy, and the resulting increase in interest rate spreads puts more downward pressure on investment than there is upward pressure on exports.

It looks to me as though the Fed is thinking that its desire to appease those in the banking sector and elsewhere who think, for some reason, that more "normal" and higher interest rates now are desirable is not in conflict with its duty as global monetary hegemon in a world afflicted with slack demand. But it looks more likely than not that they are, in fact, in conflict.