Oh no, they are saying it’s different this time

April 18, 2013

By James Saft

(Reuters) – You never like to see the words “inflation,” “central banks” and “it’s different this time” in close proximity to each other.

That, however, is the essential message in the International Monetary Fund’s World Economic Outlook, which argues that the relationship between unemployment and inflation may have fundamentally changed.

What’s more, the IMF is giving credit to central banks, which it says have inspired new confidence in their ability to control inflation.

The theory starts with a puzzle: why is it that we didn’t actually have stronger downward pressure on prices during the Great Recession? There has historically been a fairly stable relationship between unemployment and prices, which economists call the Phillips curve. Unsurprisingly, the more unemployed workers there are the more downward pressure there is on prices, and, once you get above a level of natural equilibrium, the more who are employed the higher prices go.

That relationship was not nearly as strong during the aftermath of the crisis compared to past recessions, a phenomenon the IMF compares to the dog which did not bark. Given the number of unemployed we should have seen more downward price pressure.

“In short, the dog did not bark because the combination of anchored expectations and credible central banks has made inflation move much more slowly than caricatures from the 1970s might suggest — inflation has been muzzled. And, provided central banks remain free to respond appropriately, the dog is likely to remain so.” (here#page=1&zoom=auto,0,800)

There are good reasons to give this argument some credit. A number of central banks have adopted inflation targeting, which may make their actions more transparent and more likely to inspire confidence. As well, central banks are, on the whole, more independent than they were in the 1960s and 70s, and that too must surely be known to consumers.

There is also no gainsaying the data: long-term inflation expectations around the world tend to be pretty well anchored to official targets, despite a fair amount of variation in actual inflation.

That said, this all makes me very nervous. We’ve seen macroeconomic explanations in the past which give credit to macroeconomists and it’s not always worked out so well.


Remember the Great Moderation? No, neither do I. I do remember when the world’s policy makers and their hangers-on in academia used to boast that central banks, in their wisdom, had abolished boom and bust and ushered in an age answering to that name.

This was the idea that better policy-making and central banking had smoothed out the economic cycle, leading to fewer and milder damaging busts. Then came the financial crisis, in which it revealed that we had been propping up growth and suppressing economic volatility through the generous provision of central bank liquidity and the associated build-up of debt.

In other words, there may have been fewer earthquakes but when they came they were more damaging. Some moderation.

Now here we are several years later and we are handing out credit for one of the few bright spots to the very same group of policy-makers.

The ‘great man’ theory of history, which attributes huge change not to complex forces but to the works of a few identifiable heroes, is usually as wrong as it is simplistic. We have a tendency to allocate credit and blame to that over which we have most control.

The implication of the IMF paper, of course, is that central banks, with their massive credibility, have a bit more capital to spend in fomenting growth. It also implies that they will have less trouble than many believe in capping off inflation when, or if, it actually does re-appear.

After all they are central banks, and credible. What could possibly go wrong?

The study does offer some alternative explanations for why prices fell as little as they did, notably the idea that prices face more friction as they fall closer to deflation. It is one thing not to raise prices, quite another to actually cut them.

And, the IMF also gives attention to the main other explanation, that there is a skills mismatch between those who became unemployed and those jobs that are and were out there. It is hard for an unemployed construction worker to put pressure on the wages of a nurse whose job he cannot do.

To be sure, I am not arguing against central bank independence, or inflation targeting for that matter.

Anyone who has lived through the last two decades and paid a bit of attention would do well not to put too much of their trust in central banks, much less in the economists who find them credible.

(James Saft is a Reuters columnist. The opinions expressed are his own)

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

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