The inflation news wasn't good, but it is probably safe to say that most of us would have been more surprised if the news came in lower than the forecasts. Right?
Barry Ritholtz says it best,
Everybody seems to be all abuzz about today's CPI number. Its no big whoop.
Why? At this point, I think we can all agree that a 1/4 point increase at the June FOMC meeting is a foregone conclusion. So that makes today's data more or less irrelevant to that meeting. Even if the inflation data comes in extremely benign, its but one point in a data series. Its doubtful it will impact the Fed's thinking about the next tightening in any meaningful way.
True. If this is an aberration (at what point do repeat performances stop being aberrations?), then you could argue to let-bygones-be-bygones and call off the dogs in August. But that is looking a little less likely with every data point.
Shifting the discussion only slightly, I note that Chris Dillow reads Mark Thoma and has this question among others...
Is there a danger that higher rates might actually validate high inflation expectations? The private sector might regard a rate rise not as a sign that the Fed is willing to reduce inflation, but rather as confirmation that inflation is indeed a big risk. If higher interest rates lead to higher inflation expectations, they lose much of their power to reduce actual inflation.
Not a pleasant thought. This is just another way of asking if the Fed is doing enough to raise real interest rates. Raising nominal rate just enough to keep up with inflation isn't going to cut it. But failing to keep up damages their credibility.
And so we come to the punch line. We have said for more than a year that the Fed has to get the funds rate to "neutral"--whatever people thing neutral happens to be at the time. Recall that this tightening campaign is about to reach its two year anniversary. Let's go back to the July 2004 issue of National Economic Trends (St. Louis Fed) to see what was being written then.
One simple rule of thumb for a neutral rate adds trend productivity growth, trend labor force growth, and a longrun target inflation rate together to yield a target federal funds rate consistent with the economy’s long-run growth potential and the FOMC’s inflation goal. Many analysts assign 1.0 percent for long-run labor force growth. In 1994, 3.0 percent might have been a reasonable assumption for an inflation target, whereas today 2.0 percent might be a better guess. Trends in productivity growth are harder to discern.
During the early 1990s, trend growth in nonfarm business sector productivity was often assumed to be about 1.5 percent. The three figures (1.0 + 3.0 + 1.5) then sum to 5.5 percent, and the 1994 tightening episode indeed ended with the federal funds rate just over that level, at 6.0 percent, in early 1995. But since 1994, trend productivity growth has increased. In fact, recent nonfarm business sector productivity growth has been shockingly robust: 4.9 percent in 2002 and 4.4 percent in 2003. Even if the underlying long-run trend is only 2.5 percent, that still suggests a sum (1.0 + 2.0 + 2.5) yielding a neutral federal funds rate of 5.5 percent, just as in 1994.
Annual productivity growth from 2004:Q3 through 2006:Q1 has been quite close to 2.5%, so one of those numbers is spot-on. But if inflation continues to drift upward it's going to take more than a funds rate of 5.5% to crank inflation back down to a target of 2%.
But in raising interest rates, isn't the Fed adding to inflation rather than surpressing it? This can occur both through actual costs as well as expectations. Precipitating a recession or near recession may be their only weapon.
The quote from National Economic Trends troubles me. I know that, in the long run, the productivity growth rate should be positively associated with the interest rate. But the relevant long run, I would suggest, is a matter of decades, at least. The convergence between growth rates and interest rates depends on the long-run responses of capital accumulation, which, in fact, may never happen at all. (We have the “risk-free rate puzzle,” which indicates that, over a matter of several decades, capital accumulation failed to decline in the manner that theory would predict given the generally low interest rates.)
In the time frames that are relevant for thinking about monetary policy, productivity growth is probably negatively associated with real interest rates. Rapid productivity growth means rapid growth in potential output, and, given the short-run stickiness of prices and wages (and the unattractiveness of deflation in any case), monetary growth is necessary to allow actual economic growth to keep up with potential. Accordingly, interest rates have to be kept low to produce optimal results during times of rapid productivity growth (and raised during times of low productivity growth, as Paul Volcker realized). I guess the lesson I draw from all this is that the neutral interest rate is not a very useful concept.
"One simple rule of thumb for a neutral rate adds trend productivity growth, trend labor force growth, and a longrun target inflation rate together to yield a target federal funds rate"
Correct me if I'm wrong, but isn't that the rule of thumb for long-term interest rates ? Shouldn't short term rates be 50-100 bps lower than long-term rates ?
Raphael
knzn,
I think one lesson is that the concept of a "neutral" rate should not be interpreted as logically equivalent to a short-term monetary policy target.
Actually, I prefer the Taylor rule. However as a practical matter, a Taylor rule with a 2% inflation target gives just about the same thing as in the quote above, at least right now. But I thought that the quote was interesting for the fact that I've seen some writers in the past couple years start out thinking that 4% was "neutral" and have been defining that upward. Here is an example of someone who was already thinking upwards of 5% back then. I haven't seen anyone point that out, which is why I posted it.
Everything I read and everything I observe about the economy tells me that "neutral" (if you think the term is useful) is somewhere in the 5 to 5.5% range. But the fact that we have been below neutral for so long suggests to me that we might have to go a little above "neutral" as a short run policy target to crank inflation expectations down. I also would point out that it is the real interest rate that we have to worry about. So if inflation expectations rise more than 1% in a six-month period, 25 basis point increases in the nominal funds rate may not do enough to the raise the real rate. That is troubling, as I point out above in commenting about Chris Dillow's post. If you raise rates just enough to keep up with rising inflation expectations, you're just running in place.
Your points about the short run relationship between interest rates and productivity are well-taken. They illustrate that "neutral" should be a long term concept. Short term policy should be viewed relative to that long term target. Sometimes the yield curve has to invert in order to accomplish the goal. One question this all raises in my mind is whether the recent inversion we've seen this year was enough or if another is coming. I have not made up my mind yet.
" One simple rule of thumb for a neutral rate adds trend productivity growth, trend labor force growth, and a longrun target inflation rate together to yield a target federal funds rate consistent with the economy’s long-run growth potential and the FOMC’s inflation goal. "
If I understand this corrrectly, the idea is that the neutral real rate is the underlying long run growth rate of the economy? Can anyone give me the intuition here, in two sentences?