Are you worried about inflation? Don’t be

Last summer, the Fed switched to “average inflation targeting.” The Fed’s main goal is to ensure that the PCE inflation will average around 2% over the long term and that future overshoots will compensate for any short-term discrepancies.

Although a starting point is not specified, we can assume that January 2020 is the beginning. Therefore, according to the Fed’s target, inflation should average 2% in the 2020s.
Let’s look at TIPS, a rough representative of bond market inflation forecasts:

These rates roughly represent the expected PCE inflation, as TIPS holders are compensated according to the CPI, and the CPI inflation rate tends to be about 25 basis points above PCE inflation.

There are two reasons why the TIPS spread is consistent with Fed credibility. First, what I said regarding the CPI PCE inconsistency is backward. Markets may expect the difference to be slightly lower going forward.
Secondly, there is a possibility that traditional bonds are slightly more liquid than TIPS and therefore can be sold with a slightly lower expected return, making real market inflation expectations underestimated somewhat.

The Fed predicts 2.4% PCE inflation for 2021. TIPS markets show that investors expect 2% PCE inflation in 30 years and slightly higher inflation in the next five years. All of this is consistent with the Fed’s AIT framework as some compensation is required to exceed 2% inflation in 2020. Due to AIT, the economic recovery will likely be much faster than during 2009-19.

This is a success. Of course, I prefer NGDP targeting more and if they need to target inflation, I would prefer PCE targeting, but even the successful implementation of AIT would be pretty good compared to the 60s, 70s, 80s, and 2010s.

So what will the Fed do in the 2020s? Will inflation be on average 2% or more? Currently, the markets expect a modest increase in the next 5 years to compensate for the low inflation in previous periods. And then roughly 2% inflation. Isn’t that what the Fed says it wants?

If the markets think that this outcome will require higher interest rates than the Fed currently sets, I don’t think it is correct to interpret this as a lack of policy credibility and I prefer to describe it as a difference of opinion. If markets did not expect inflation to average 2% in the 2020s, we could speak of a lack of policy credibility. However, these rates show that confidence in the Fed has increased. Moreover, maybe it would be much better to act a little more “irresponsible.” The Fed was too “responsible” for a long time.

Some fear that all this could get out of hand at some point and result in higher inflation than it should have been. There is a way to see this:

If we experience high NGDP growth during the 2020s (i.e. More than 4%), we will have high inflation. If there is 4% growth, there will be moderate inflation. If we have less than 4%, the Fed would be below its target. It’s all about monetary policy. When it comes to inflation, fiscal policy doesn’t matter. Fiscal stimulus does not matter. And markets are optimistic.

Will the Fed give us 2% inflation in the long run, or are they a bunch of liars? I’m trusting them right now, but we’ll see.

P.S: David Beckworth and Ramesh Ponnuru has an excellent piece about this issue:

The evidence that high inflation is on the way is weak. It’s too weak, actually: An economy on the verge of a robust recovery would be showing more signs of rising inflation. Right now, inflation appears more likely to stay below its optimal level than above.

Read the whole thing.

NeoFisherian experiment in Turkey: Here we go again

Yesterday Erdogan dismissed the head of the Central Bank of the Republic of Turkey’s, Naci Agbal, and replaced him with professor Sahap Kavcıoglu. In a previous post, I claimed that Turkey has willingly or unwillingly adopted a kind of NeoFisherian policy. In this post, I will discuss this case within the framework of this hypothesis.

During the presidency of Naci Agbal, we witnessed a significant increase in interest rates and the adoption of a tight monetary policy. The main purpose of these policy changes was to lower the exchange rates and give confidence to the markets. Some of these have been successful. In the last few months, we have seen a serious drop in the exchange rate, but it was clear that this would not be sustainable: The Turkish lira began to depreciate again as soon as Erdogan mentioned former Finance Minister, and his son-in-law, Berat Albayrak.

I will not mention here the fundamental problems of Turkey’s economy. In a country like Turkey more fundamental, problems are closely linked to politics. However, these are not covered by this post.

Still, you need to be familiar with current political discourse and ideologies to understand the economy of Turkey. If you look from the outside, perhaps Erdogan and the CBRT will appear as a government that rationally follows NeoFisherian economic policies.

Yet, this is not the case. The dominant faction in Turkey, low rate supporters, justify their views with religion, not economic theory. However, it would not be correct to say that they do not decorate the cake: low foreign exchange value, increase in exports and decrease in imports, and finally cheap labor.

Despite everything, as I argued earlier, Turkey’s economy can be considered a kind of NeoFisherian experiment. Sahap Kavcıoglu made the following statement this morning:

“While the decline in inflation will positively affect macroeconomic stability through the decline in country risk premiums and permanent improvement in financing costs, it will also contribute to the creation of the necessary conditions for sustainable growth that will increase investment, production, exports, and employment.”

In other words, rates will fall.

As I wrote before:

So, how is that NeoFisherian experiment going in Turkey?
Neofisherians claimed that a decision by a central bank to lower its interest rate target or engage in QE is generally expansionary. However, it is not possible to see anything here that can support this claim. But I doubt that it will cause any NeoFisherian’s to say, “Doh!”

Here I will repeat the same claim. In my opinion, both sides make the fallacy of “reasoning from a price change.” The current political and economic debate in Turkey is almost exclusively done via interest rates and exchange rates. Although interest rates have made no significant changes to monetary policy, it is at the heart of the debate. This debate is not an economic one(discussion on economic theory in Turkey does not make sense for this reason). But what I’m more interested in is what this experiment tells us about interest rates and NeoFisherianism, rather than this debate.

This experiment not only shows that NeoFisherians were wrong and low-interest rates aren’t expansionary. I believe there is more to see. High rates don’t cause inflation, just as low rates do not cause inflation. They are relatively unrelated to other variables in monetary policy. They do not give signals whether the monetary policy is tight or loose. Pretending to be like that means making the fallacy of “reasoning from a price change, “and it’s a cancer cell that spreads the vast majority of your comments on monetary policy.

Fortunately, markets are smart enough to understand this. Unfortunately, it is not possible to say this for Erdogan and his political party.

P.S: Check this out:

Money Matters

Note: I originally designed this post as a separate post, but it changed as I continued to write. At one point, I realized that I needed to write the background for the first post of the “Back to Basics” post series, as even in this form there were points left behind that needed to be clarified. Therefore, this post can be read as “Back to Basics, pt. 0”. If you are going to read the series, it’s best to start from this point.

From the beginning, I have been thinking about how to learn the money economy, how to shed light on the confusing concepts that are confused. Later, I realized that when people learn about monetary economics, they must forget what they believed before.

Market monetarist economists believe that monetary shocks are the main cause of business cycles and that they are the only cause of unemployment fluctuations. People don’t believe it; This is not clear even to most economists. The ordinary person thinks the recession is due to big real shocks or financial shocks: explosion of asset bubbles, 9/11, stock crashes, disasters…

It will probably seem difficult to get rid of these “real” theories at first, but the more you think about it, the more likely it is that the foundations are rotten and can be easily broken down. It is easy to see that 9/11 did not cause the 2001 recession, because the recovery started after 2 months. One of the biggest stock market crises in the last 50 years occurred in 1987, almost identical to 1929, including a recovery in stock prices. The biggest natural disaster to hit a wealthy country in the last 20-30 years was the 2011 Japanese earthquake that killed tens of thousands of people, devastating a large area of Japan and its entire nuclear industry (25% of total electrical energy).

The next two graphs show the unemployment rate 2 years before and after the October 1987 crash and Japan’s unemployment from January 2009 to 2015(the tsunami was in March 2011):

What do we see here? Absolutely nothing. These real shocks do not matter much to business cycles. The tsunami, of course, caused a temporary drop in industrial production, but nothing severe enough to create a recession. You can really see how little real shocks matter if you turn your attention to the labor market. Because real shocks do not cause big jumps in unemployment. Recessions are due to unstable NGDP, which is due to unstable monetary policy(by definition, stable NGDP growth is my definition of stable monetary policy). However, it’s not a tautology that the recessions themselves are caused by monetary policy. It is surprisingly difficult to explain why NGDP instability has caused unemployment to fluctuate so much. Especially when NGDP shocks are caused by quite obvious changes in monetary policy rather than “errors of omission.”

Let’s look at another example. In the US, residential construction fell 50% between January 2006 and April 2008. So what happened to unemployment? It rose from 4.7% to only 4.9%.

Many people, and even some economists, grossly overestimate the importance of real shocks in the business cycle. On the other hand, again, most people and some economists vastly underestimate the importance of monetary shocks. If we’ve got rid of the idea that non-monetary shocks cause recessions, it’s time to talk about monetary policy as the real cause of business cycles.

First, it is necessary to explain why money is important for nominal variables such as inflation and NGDP. After that, we can go back to the business cycle.

The key concept we will use from now on is the value of money, and it is defined as:

Value of money = 1/(Price Level)

This definition actually comes from basic microeconomics. We move away from simple supply and demand curves in upper-level micro-lectures and start talking about “relative prices” or “real prices.” Therefore, if the CPI rises by 10% per year, then the prices of goods that increased by 8% declined relatively, and those who experienced a 12% price increase relative to their price increase. Relative price is the actual price relative to the price of all other goods in the economy. Now let’s do the same with money. What is the nominal price of money? One. So what is the real price? We call this the purchasing power of money; it shows how many goods you can buy for each dollar. This is only 1/price level. Thus, if the price level doubles, the money’s purchasing power, i.e., the value, falls by half.

The field of monetary economics exists for a reason – money is the medium of account, the commodity we use to measure all other values. Most textbooks oversimplify this concept by combining the two ideas into “units of account.” Currency banknotes are the medium of account, which is used to measure value. Abstract accounting units such as the US dollar and Euro are examples of units of account.

Because money is good for pricing all other goods, almost every change in the value of money affects changes in price level and other nominal variables. I have to remind you that this is not a “theory” but a definition. The theory will come later, asking whether government policymakers can control the price level through “monetary policy.”

While studying the monetary economy, the most efficient example on this subject was the metaphors that Irving Fisher used money as a measuring stick. I’ll first give an example with price level; then we’ll see the same example with measuring sticks:

In 1996:
Income $20,000
Price level 1.0
Real income $20,000.

In 2021:
Income = $120,000,
Price level = 3.0
Real income = $ 40,000.

This means that prices have tripled in 35 years, and a person’s income has increased 6 times. He can now buy twice as many goods and services. This is derived as follows:

Real income = $ 120,000 × (1.0) ÷ (3.0).

Let’s see the same example on the measuring sticks, our example would be the height of a child:

In 1996:
Height = 1 yard
Real height = 1 yard

In 2021:
Height = 6 feet
Real height = 2 yards

The child is 6 times bigger in nominal terms, but only twice as tall in real terms. No one would believe it if his father claimed that his son was 6 times taller. This is usually not possible. However, it is claimed that we made 6 times more money in 2021 than in 1996, and they make the same mistake that the father did: 1996 dollars are thought to be the same as the 2013 dollar. But that’s not true, the value of each dollar today is only 2/3 of 1996 dollars. We can say that those who made this mistake suffer from the “money illusion.”

Let’s imagine that we are using something other than cash as money. If oranges were money, a large harvest of oranges that degraded the orange would cause too much “inflation.” In fact, we are experiencing a lot of “orange inflation” when the relative price of oranges falls anyway. And, for example, when the relative value of silver rises, we experience a lot of “silver deflation”. Why do we only care about money inflation and not other types of inflation and deflation? This is a difficult question to answer. Textbooks have two sections devoted to this:

  1. Welfare costs of inflation.
  2. Welfare costs of business cycles.

In theory, measuring sticks don’t matter. No matter what you measure objects with, their actual dimensions do not change. But imagine a country where for some reason people make contracts to supply 100 “units of wheat” within 12 months in the future and units are left unspecified. Or let’s say people agreed to work at 2 units of wheat per hour next year. Suppose, moreover, that the government can change units from pounds to pounds and ounces at any time. In this case, a change in units will definitely affect the public. This is the main reason why monetary inflation is important and orange inflation is much less important. Our measuring stick always changes in value and this causes a lot of problems.

Now that these points are clear, we need to explain why the value of money has changed. In a post series.

Back to Basics, Pt. 4: The role of expectations

In the previous post, we examined the Quantity Theory of Money. We have seen that increases in money growth rate lead to high inflation leading to higher speed and lower real money demand. This indicates that when it comes to a rise in the money supply growth rate, in the long run, the price increase will be more than the increase in the money supply. Conversely, when it comes to slow money growth, inflation slows down, which lowers the opportunity cost of holding the base money, so the demand for money increases and the price increase is less than the money supply. This is one of the ways expectations play a role in the money and inflation equation.

There are a few more interesting examples. These happen when there is a change in the monetary base’s expected future level but no change in the current base. Here are two examples of this:

  1. A new government is elected, and there is an expectation that a lot of money will be printed. This expectation of an increase in the money supply raises prices. A clear example of this occurred between March 1933 and February 1934, when the Wholesale Price Index rose more than 20%, but there was no increase in its monetary base. People correctly expected that the dollar’s devaluation would lead to a higher money supply in the coming years. The increasing current base velocity reduced real money demand, and prices increased.
  2. The opposite is also remarkable. This happens when a government injects large amounts of money into the economy but tells the public that it will end as soon as there is a sign of inflation. In this case, the interest rate will drop to zero and the public will hold much larger real cash balances. The best example of this situation occurred in Japan in the early 2000s. By 2006, too much base money was injected, and in 2006 the monetary base was lowered by 20% to prevent inflation from occurring.

The conclusion to be drawn here is that the current path of inflation is affected by expectations too much. But of course, the expectations must be about something, and in this case, they are about the monetary base and the changes in its demand in the future. If we completely ignore the expectations, we can conclude that the “hot potato effect” drives the long-term relationship between money supply changes and changes in the price level. However, current inflation will be more likely to affect the expected future hot potato effect when expectations come into line.

Unfortunately, the role of expectations makes the monetary economy much more complex. This situation causes us to experience a problem that can be called a kind of “indeterminacy problem” or “multiplicity of solutions”. Several different future pathways for the money supply can be associated with any price level. Alternatively, there are many different price levels (including infinity) consistent with any available money supply. Therefore, if the public believes that the money will be declared null and void next week, it may have no value today. Confederate money towards the end of the Civil War is a perfect example of this. So there must be some kind of confidence in the background that money will have purchasing power in the future.

In the next step, we will see that monetary policy affects prices and has real effects, and we will examine the reasons for this.