All consuming inflation

October 28, 2013

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Why, during the Great Recession, with a sputtering economy and increased unemployment, didn’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 didn’t fall in the Great Recession, the researchers find, is that businesses follow households’ 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 Gorodnichenko’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 researchers’ findings are a significant update to economic thinking on inflation. “For 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,” he writes. Then the 1970s happened, and economists began to pay more attention to inflation expectations.

James Pethokoukis concludes that “if we all didn’t know that America was destined to again experience the scourge of rapidly rising prices”, the data from recent years “might suggest deflation is the bigger threat”. 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 consumers’ persistently high inflation expectations “makes it much more difficult for the Fed to try to justify its actions to the public on the grounds that inflation is currently too low”. And arguing for more inflation in the economy, according Binyamin Appelbaum’s reporting over the weekend, is precisely what the Fed is about to do. — Ben Walsh

On to today’s links:

The last 20 years were “the profoundest reshuffle of people’s economic positions since the industrial revolution” – John McDermott

Popular Myths
Amazon and the “profitless business model” fallacy – Eugene Wei

Goldman Sachs’ charitable foundation is “run as if it’s a Broadway show” – Susanne Craig

Why higher inflation would help the US economy – Jared Bernstein

What happens when a prominent tech writer asks to be hacked – Pando Daily

Tax Arcana
The man who helps big companies save billions in Irish tax havens – Bloomberg

EU Mess
Italy’s demographics problem is almost as bad as Japan’s – WSJ
The lower-tax movement is gaining in one of Europe’s high-tax regions – Quartz

A great discussion on leaks and the future of news between Glenn Greenwald and Bill Keller – NYT

Long Reads
The New Agent Orange: Is America’s army making its soliders sick? – The Verge

The co-inventor of the mortgage bond on 6 ways to fix the housing market – WSJ

Popular Myths
No, math ability is not mostly genetic – Miles Kimball and Noah Smith

“Purchasing vineyards is an excellent method to launder money” – South China Morning Post

Right On
Quality is speed – The Cutting Ledge

Sad Declines
The problem with Canadian men (economically, that is) – Worthwhile Canadian Initiative

Do You Have To Ask?
“Coffee v smoothies: Which is better for you? – BBC

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One comment

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Some typos in this article. See: “…Including weak job job growth, lower demand, and falling investment and spending.”

And possibly : “There are many good reasons to monetary policy should aim higher on inflation.” The ‘to’ I believe.

Posted by Sinjin.H | Report as abusive