Friday, May 26, 2017

China vs the Trilemma, Price Level Path, Balance Sheet Confusion, and FOMC Debates

Here are some assorted macro musings from the past week:

1.  Been there, done that, and it did not end well China edition. Once again, China forgets there is a macroeconomic trilemma. From the Wall Street Journal:
China’s central bank is effectively anchoring the yuan to the dollar, a policy twist that has helped stabilize the currency in a year of political transition and market jitters about China’s economic management.... 
The newfound tranquility may not last: The focus seen in recent weeks on stability against the dollar, whether it goes up or down, means pressure on the yuan to weaken could get dangerously bottled up, potentially bring bouts of sharp devaluation.
Pegging an exchange rate, tinkering with domestic monetary policy, and allowing some capital flows can be a dangerous game to play. Chinese officials should stare long and hard at the picture below and recall how by ignoring it they created a crisis back 2015

2. St. Louis Fed President James Bullard notices the U.S. economy is falling off of its trend price level path in a recent speech.

In short, the Fed’s normalization plan calls for it to prop-up banks’ demand for cash, as a prelude to reducing the supply of cash! That means tightening and more tightening. The rub, of course, is that conditions may never justify so much tightening. What's more, no plan for Fed normalization can work that would prevent the Fed from meeting its overarching inflation and employment targets.

4. Peter Ireland on what we can learn from the FOMC debates as seen in the latest minutes. Among other things, Peter notes the following:
Digging into the details of the FOMC’s debate reminds us, as well, of important lessons from economy history. Participants who warn that low unemployment today raises the risk of higher inflation in the future are organizing their thoughts around the idea of the Phillips curve, which describes an inverse relation between those two variables. One lesson from history, however, is that while data do often support the existence of a statistical Phillips curve, its fit is not nearly strong enough to serve as a fully reliable guide for monetary policymaking. The limitations of the Phillips curve approach became clear, for example, during the 1970s, when chronically high unemployment was accompanied by rising, not falling, inflation. Today, we may be seeing something similar: unemployment is below 4.5 percent, yet inflation continues to run below the Fed’s long-run target.     
In fact, as other participants in the debate point out, inflation has been below target for the past eight years. If one accepts Milton Friedman’s famous dictum, summarizing historical experience that “inflation is always and everywhere a monetary phenomenon,” it is difficult to escape the conclusion that, despite an extended period of very low interest rates, Federal Reserve policy over this period has been insufficiently, not overly, accommodative. This echoes another lesson from the past. Milton Friedman, Anna Schwartz, Allan Meltzer, and Karl Brunner all concluded, likewise, that very low interest rates during the 1930s accompanied, and indeed were the product of, monetary policy that was consistently too restrictive.  


  1. I'm still waiting for a reason to have a price trend above zero. Moreover, any price trend that is expected should be as good as any other, according to today's rational expectations theory. Not sure what Bullard is worried about. Even if price inflation drives output (there's no empirical connection), it is only a short-run phenomenon and adjustments will be made quickly.
    Still looking for some benefits to any inflation...

    Pete Bias

    1. Pete, so what is your theory of where the price level trend should be?

      Bullards concern, I believe, is that if the people made economic decisions under the expectation that price level would rise on average 2% and then an unexpected undershooting occurs it wrecks havoc on their plans.

    2. Hi David,

      I agree that's a legitimate argument. If that is indeed the expectation then movements away from that expectation will create misallocations.
      Question is, are new expectations being made given the new trend? If so, then a movement back to 2% is possibly equally problematic.
      Don't know the right answer.
      Ultimately my preference would be for a zero price trend if we could get there and stay there.

      Pete Bias

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