All consuming inflation
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Why, during the Great Recession, with a sputtering economy and increased unemployment, didnâ€™t prices fall in the US? Instead, prices have risen, albeit much slower than normal. A new paper by economists Olivier Coibion and Yuriy Gorodnichenko puts that question in more precise, academic terms: why has the US had really low levels of inflation, when instead, they assert, economic theory says there should have been disinflation (falling prices)?
The reason prices didnâ€™t fall in the Great Recession, the researchers find, is that businesses follow householdsâ€™ lead on inflation expectations. And households have an unorthodox way of setting their inflation expectations: they pay a lot of attention to gas prices, which rose after the financial crisis. This is a marked difference from how academics and businesses gauge inflation: they intentionally exclude oil prices from their primary inflation metrics, in part because they are so volatile.
Coibion and Gorodnichenkoâ€™s findings suggest a new relationship between consumer inflation expectations and unemployment. Previously, both business and consumer inflation expectations and unemployment had been strongly correlated. But in the Great Recession, this relationship broke down. Unemployment increased dramatically, and inflation stayed higher than predicted.
James Hamilton writes that the researchersâ€™ findings are a significant update to economic thinking on inflation. â€śFor nearly a century, many economists have viewed variation in the unemployment rate as a key determinant of why inflation is higher in some years than in others,â€ť he writes. Then the 1970s happened, and economists began to pay more attention to inflation expectations.
James Pethokoukis concludes that â€śif we all didnâ€™t know that America was destined to again experience the scourge of rapidly rising pricesâ€ť, the data from recent years â€śmight suggest deflation is the bigger threatâ€ť. Pethokoukis runs through the dangers of deflation, including weak job job growth, lower demand, and falling investment and spending.
There are many good reasons to monetary policy should aim higher on inflation. However, Hamilton thinks consumersâ€™ persistently high inflation expectations â€śmakes it much more difficult for the Fed to try to justify its actions to the public on the grounds that inflation is currently too lowâ€ť. And arguing for more inflation in the economy, according Binyamin Appelbaumâ€™s reporting over the weekend, is precisely what the Fed is about to do. — Ben Walsh
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