Inflation appears to be diminishing. Traditional change from a year ago:
Month-to-month changes are now suddenly more common on the way down than they were on the way:
Standard Financial Theory 101 says that the $5 trillion financial explosion will cause an increase in the price level, to inflate debts owed. But that inflation eventually goes away, even if the Fed does nothing. It disappears a little faster if the Fed raises interest rates. Central Chart: Here’s what happens in response to a major financial shock, if the Fed does nothing. Inflation is rising, but it is fading as the new debt swells.
So while inflation was still on the rise, starting here, last March, here at length for the Hoover monetary policy conference published under the title “Inflation Past, Present, and Future,” and further shortened here with the first draft of “Financial History,” Here clearly from continuous time models, here in the Wall Street Journal and here in pictures, here in the first draft of “Outlook and Interest Rate Neutrality,” I came out in a position with the view that inflation will subside, even without the Fed dramatically raising interest rates. Then, it was updated here as did inflation after it started to ease off. (Okay, looks like I’m making the same point multiple times!)
I call this the “Second Great Experiment,” as the traditional theory goes, the Fed needs to raise interest rates significantly above current inflation to bring down inflation.
Now, to Luther’s point of view. Isn’t this a victory round for the view that inflation is just “supply shocks” that disappear on their own?
No, a “supply shock” would raise prices temporarily, and then the prices It will return to normal once the shock of the show is over. A supply shock alone cannot permanently raise the price level. How does the price level work?
Cumulative inflation has pushed the price level up by 10-20%, depending on what you think about the previous trend. The pure “supply shock” view says we should now experience a symmetric period deflation To bring price level Back to where it was, or at least to that in addition to the 2% trend. Financial theory or the “demand” view says that this price level shock is permanent, or at least until something else comes along; It will be necessary to reduce financial expenditures to bring down the price level to where it was.
Well, that hasn’t happened yet. The current end to inflation does not prove the “supply shock” view correct. Maybe you will. If we get a period of 10% deflation, unrelated to Fed action such as inflation, the supply shock outlook could take a “we told you so” turn. Although, of course, nothing in economics is that simple.
what happened after that? In the simple financial theory model, the Fed could lower inflation today, but only by making future inflation a little worse. This is also desirable. For a recent round table on economic policy at Hoover, I made the following chart:
The beginning is the same as the last chart – responding to a 1% financial shock when the Fed does nothing. Now I ask, what if the Fed waited a year and then started raising interest rates. You see in the short term that the Fed is cutting inflation faster than it could go down. However, we will have to inflate the debt at some point unless fiscal policy wakes up and decides to pay it off more aggressively. So we get more inflation in the long run. I call that “unpleasant interest rate calculation.”
This leads me to worry about the future of 1975:
Inflation comes down without much Fed intervention, and we all cheer, but then it stalls at maybe around 4%. And we await the next shock, amid the dreaded arguments of the 1970s that we must get used to inflation, raise the inflation target, and it’s too expensive to lower it, or is it really all about workers-managers conflict in prices anyway.
I’m more wary of this. The graph of the effects of monetary policy has unstable components in it. However, you should use the form you have, not the form you wish you had.
On a note of optimism, long-term expected inflation and the price level remain in Fed control, even in my fiscal theory model. After the financial explosion has been blown away, the Federal Reserve can gently normalize the situation. The step of the ladder is not realistic, of course, but it is designed to show the mechanism.