The Fed Finds Religion

by: Macro Man

Has the Federal Reserve found religion? Yesterday's verbal barrage from a host of Fed speakers, both voters and non-voters, suggested that the FOMC has started to notice that the cost of living is going up. A lot. It is probably through that prism that yesterday's strong US retail sales report should be viewed; it is hard to credit that spending growth has encompassed much beyond basic necessities. Such a conclusion, at least, is the least that can be reached on the basis of a chart posted on The Big Picture yesterday.

Now, central banks are in a tough spot here. One might (and indeed, Macro Man would) argue that the Fed has found religion after the inflationary horse has already bolted. Still, perhaps it's better to see straight late than never; less clear is what to do about it. An obvious starting point is to quit inviting financial markets to shag the dollar, and it is through that prism that the Treasury's recent volte face should be viewed. It seems as if US officials have connected the dots and realized that the dollar down bubble might have at least a little to do with import prices rising 15.4%, and moreover that this imported inflation is being passed through domestically.

The Bank of England is in a similar boat. The macro data has deteriorated markedly; today saw the first rise in unemployment claims in more than eighteen months; meanwhile, the news from the housing market remains nothing short of execrable. Yet inflation remains persistently high; for an inflation targeting central banks, this makes aggressive easing on the back of weak activity data difficult, unless one assumes an endogenous disinflationary impact from lower growth.

And throughout the history of inflation targeting, that's been a reasonable assumption. Yet one could plausibly argue that for the first time since the 1970's, global inflation is largely exogenous for most countries, a product of the three axioms and prior underinvestment. In such a case, it's unclear that high rates will do much to ease headline inflation. On the other hand, tight policy can, on the margin help prevent the second round effects that helped to endogenize the external inflationary shocks of the 1970's.

Macro Man is starting to wonder if we're aren't seeing the beginning of the end of inflation targeting as we know it, much as the 1980's spelled the doom for monetarists. Targeting inflation is great in a world an endogenously-generated price rises when core and headline converge over time; in a world of exogenous inflation pressure and divergent core and headline, focusing on one inflation measure is likely to generate suboptimal policy.

Macro Man wonders if we won't move towards a a world where central banks begin to target nominal GDP growth, rather than simply inflation. In a world of exogenous inflation, high frequency tradeoffs between growth and inflation are, to a degree, out of the central bank's control; if those shocks feed through into domestic prices, this will be reflected in nominal output growth.

What's interesting is to look at a chart of nominal GDP growth in the US and three other inflation-targeting central banks. In New Zealand, nominal GDP growth is just north of 8% y/y...close to the level of the RBNZ's OCR. In the Eurozone, nominal GDP growth is just over 4% y/y....again, close to the ECB's refi rate.

Interestingly, nominal GDP growth in both the UK and US are well above the respective central bank policy rates. Small wonder, then, that the dollar and sterling are two of the three worst performing G10 currencies this year (the third, the Canadian dollar, also has a central bank policy rate well below the level of nominal GDP growth.)

So if central banks do find a new religion, it looks like the conversion may be easier for some than for others.

(And yes, I know that trailing y/y nominal GDP growth rates are not optimal policy targets; in an actual nominal GDP target regime, forward-looking indicators would be used.)