Comments 21

The Inflation Puzzle

May 29, 2015 Martin Feldstein

The low rate of inflation in the US is a puzzle, especially to economists who focus on the relationship between inflation and changes in the monetary base. To solve it requires understanding the change in the role of the reserves that commercial banks hold at the Federal Reserve.

CAMBRIDGE – The low rate of inflation in the United States is a puzzle, especially to economists who focus on the relationship between inflation and changes in the monetary base. After all, in the past, increases and decreases in the growth rate of the monetary base (currency in circulation plus commercial banks’ reserves held at the central bank) produced – or at least were accompanied by – rises and falls in the inflation rate. And, because the monetary base is controlled directly by the central bank, and is not created by commercial banks, many believe that it is the best measure of the impact of monetary policy.

For example, the US monetary base rose at an annual rate of 9% from 1985 to 1995, and then slowed to 6% in the next decade. This decelerating monetary growth was accompanied by a slowdown in the pace of inflation. The consumer price index (CPI) rose at a 3.5% rate from 1985 to 1995, and then slowed to just 2.5% in the decade to 2005.

But then the link between the monetary base and the rate of inflation was severed. From 2005 to 2015, the monetary base soared at an annual rate of 17.8%, whereas the CPI increased at an annual rate of just 1.9%.

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Martin Feldstein

Writing for PS since 2008
112 Commentaries

Martin Feldstein, Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research, chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984. In 2006, he was appointed to President Bush's Foreign Intelligence Advisory Board, and, in 2009, was appointed to President Obama's Economic Recovery Advisory Board. Currently, he is on the board of directors of the Council on Foreign Relations, the Trilateral Commission, and the Group of 30, a non-profit, international body that seeks greater understanding of global economic issues.

0 Comments on this paragraph, 21 in all 21 Comments on this article

Laurence COPELAND Jun 9, 2015

Surely the main reason inflation hasn't taken off is because there is a global excess supply of labour - we are in a global economy (which is really a new phenomenon dating back only about 20 years), so the US unemployment rate is irrelevant. Excess demand for goods is satisfied at constant prices from China, India etc The excess money supply therefore goes to push up the demand for nontraded services and assets
Leo Kolivakis Jun 4, 2015

My latest discussing America's retirement nightmare:

http://pensionpulse.blogspot.ca/2015/06/americas-retirement-nightmare.html

Best regards,

Leo Kolivakis

Publisher of Pension Pulse blog.
Pablo Klein-Bernard Jun 3, 2015

Follow this analysis to its full consequences, one cannot escape the conclusion that the economic stimuli provided by all rounds of Quantitative Easing is shallow, transitory and dangerous. The traditional channel of financing of investment projects through bank lending (aka boosting the real economy) has been eschewed in favor of providing stimulus thorough inflating the wealth of the upper classes who own most of real estate and financial assets. But this is precisely the less efficient way of boosting demand because, as we all know that the expenditures of the rich are not contingent on their income or wealth. They will afford that mansion or yacht independently of whether they have 100 or 500 millions in the bank.
But the side effects of real estate and stock market bubbles for propping up the economy is that it becomes more prone to 2007 style crashes and more vulnerable when those happen. I am particularly worried by the recent economic data, where Q1/2015 appears to confirm yet another false start of the US economy.
Cornelia Arbitrot Jun 2, 2015

"Nonetheless, inflation will head higher in the year ahead. Labor markets have tightened significantly, with the overall unemployment rate down to 5.4%. The unemployment rate among those who have been unemployed for less than six months – a key indicator of inflation pressure – is down to 3.8%."

Mr. Feldstein, echoing some other comments here, Paul Krugman has intellectually pummeled you over the past few years about your inflation fixation in the face of the zero lower bound, which you disingenuously mention only in an indirect too clever by half CYA mode ("... negative interest rates").

Other than your Republican proclivities, why would you not mention who your principal critic in the discipline is? Maybe his Nobel prize disqualifies him from your Olympian consideration?

Or is it that this blog service has promised you a piece of the -- very small, trust me -- action if any of your columns are picked up by gullible newspapers, magazines, or whatever who may see your Harvard affiliation and figure:

"Oh, this guy must be good. He's Emeritus at Harvard."

Of course even they wouldn't pick up your retreaded nonsense if you had engaged directly with Krugman in the column.

"Yes, Paul Krugman has been telling me for 6 or so years now why I have been wrong, and why. Oh, did I forget to mention that I have been wrong? Anyway, you just wait and see. He'll end up being wrong by this time next year."

Why don't you do this for us, Mr. Feldstein? You have made a flat out prediction about how inflation will not only be higher next year, but will be on its way up to a degree that the Fed will have to raise interest rates beyond what it is currently targeting for next year.

So, if this service is still in existence, why don't you make an intellectual -- and moral -- commitment to write a new column this time next year addressing how your prediction is working out, with appropriate analysis.

Even if Project Syndicate is no longer in existence -- probably because the contributors are tired of looking like idiots taking their $2.44 royalty checks to the bank for deposit -- send the update column to the New York Times. I'm sure they'll be delighted to print it cheek-by-jowl on some Monday or Friday with Krugman's column.

May the economist with the most intellectual and moral integrity win!
George Hovey Jun 2, 2015

I'm not an economist. Could Mr Feldman's column be an illustration of the old gag "how many economists does it take to replace a light bulb? [None. When the bulb they were given in grad school fails they sit in the dark.]
ezra abrams Jun 2, 2015

Dear Prof Feldstein
If I may say so, it is somewhat insulting to your readers that you don't explicitly deal with the ZLB arguments raised by others, such as P Krugman.
I know nothing, but when I see you write a column that doesn't deal with issues raised by others, I get suspicious.

I think, as a minimal courtesy to your readers, that you should also deal with the argument that the magnitude of the interest paid on banks funds at the fed is so small that it is not significant; again, I know nothing, but i find it suspicious that you don't deal with this or even mention it
Avraam Dectis Jun 2, 2015

.
Another thing that seems odd is that the labor participation rate is down about 5% from its peak, essentially a 40 year low.

If all the other stats say we have a tight labor market but the labor participation rate says 5% of the available workforce somehow stopped working, is it not possible that we do not have a complete understanding of the truth of the situation?

Thank You.

Avraam Jack Dectis
Sam Brasel Jun 2, 2015

When interest rates are at the ZLB, it is possible that they are artificially *high*; that is, they are above the rate at which the capital markets would clear. If true, this would create a glut of capital (this is what actually happened). When there is a glut of something such as capital, and an entity such as the Fed goes and purchases a lot of that something it is possible that one will still have a glut even after the purchases are made, thereby having no effect on prices...or the inflation rate. Puzzle solved!
Sam Brasel Jun 2, 2015

Interesting. There is no mention of the zero-lower-bound in this post. None whatsoever. Interest rates are at the ZLB for the first time in Martin's lifetime and his inflation predictions since the ZLB occurred have all fizzled, and he sees no possible connection between those two events. Interesting.
Sam Brasel Jun 2, 2015

"[the Fed] may be forced to increase interest rates rapidly, with adverse effects on financial markets and potentially on the broader economy."

Um, Martin, adverse effects can also occur when the Fed increases interest rates *slowly*, if it raises them prematurely. In other words, people who have itchy increase-rates fingers shouldn't work at the Fed.
E Walker May 31, 2015

For those interested in learning something about the relationship between banks and the monetary system, which Feldstein obviously isn't, try Modern Money Theory, by Randall Wray.
David Neunuebel May 31, 2015

So after the whole article the author ends with a rather alarmist yet unlikely scenario that inflation might "rise faster than the Fed expects" and cause adverse effects on financial markets and the economy, something that is pretty unlikely but we're left with that as we leave the article.
Vincent Cate May 30, 2015

Here is my post on how we know high inflation is coming:

http://howfiatdies.blogspot.com/2014/01/how-we-know-inflation-is-coming.html
Vincent Cate May 30, 2015

High inflation is a positive feedback loop or death spiral. Conditions build up for a chain reaction and then something triggers it and things happen fast. I think Japan and the USA are headed for that.

http://howfiatdies.blogspot.com/2014/08/positive-feedback-theory-of.html
Walter Gingery May 30, 2015

The only puzzle is why Feldstein should think a puzzle exists. No demand = no borrowing = no economic expansion = no employment growth = no inflation.
- John Quick Jun 2, 2015
  
  No puzzle, Walter. When the righties deny that our economic woes arise from lack of demand, then your chain falls apart.
Gunnar Eriksson May 30, 2015

The lack of correlation is just that during the last 15 years the economy has worked like a vacuum cleaner sucking funds from those with very little to those with very much.
Any Farmer knows that it is fruitless to spread fertilizer on the dung heap.
jagjeet sinha May 30, 2015

Inflation' s correlation with the Monetary base was perhaps just one of several causative factors in a multi variate function that is at the heart of explaining inflation. Asset prices - householders capacity to fuel demand critically dependent on the Value of their principal asset - perhaps have a greater coefficient of discrimination in explaining inflation than hitherto believed. In the decade 2005 - 2015, if the Monetary base expansion was 17.8 % and inflation 1.9 %, perhaps the explanation lies in the enormous quantities of liquidity that was needed to bolster Asset prices back to ensure demand was restored by householders heightened capacity via Asset prices. Deleveraging effects on householders demand capacity had to be offset - by leveraging on The Fed's balance sheet. $ 4 trillion injection perhaps explains the 1.9% inflation better than the 17. 8% expansion in the Monetary base. The return of Asset prices to a positive slope needed $ 4 trillion liquidity injection in 2008 - 2014, in the future when leveraging returns to householders balance sheets the figure may morph into an even larger dosage.
The salutary effects of Energy prices and stronger dollar is perhaps a result of 'Superpower premium', that has hitherto never been quantified. 'Superpower Assets' have Value, that can bring commodity prices to levels needed to manage domestic inflation. The State balance sheet after all is the source of funding Quantitative Easing as well as Superpower Valuation - both releasing helicopter monies into the Economy, by State spending.
Procyon Mukherjee May 29, 2015

Fed's massive bond buying programs ended in October last year and the excess reserves have remained at the same level since then. There is neither any urgent need to liquidate this from the Fed side at least, nor is the economy forcing banks to release this stock into meaningful activities which could have raised the prices of goods and or wages.
Feldstein has raised a pertinent point that connects the strong dollar to the tempering of prices as imports provide a stronger competition. The growth in wages, albeit higher than the inflation is moderately endorsed by the growth in M2, but whether this is just a flash in the pan can only be confirmed as we move through a few more quarters.
camille hurn May 29, 2015

So the evidence is that monetarism is wrong and that in the recent environment loose monetary policy does not prevent falling prices, which has been the case for the past five years, yet this is only temporary? Are you areguing that because traditional monetarism is wrong about this, then the Phillips curve must be true? I'm not sure the answer to what we are facing in the advanced economies is so simple. Is it time to bet on the Fed interest rate decision . I'll sell the put - any takers?
Burdin Hickok May 29, 2015

Professor, I do not regularly comment on articles though I am commenting here in hopes that you may offer a brief response to my interpretation of why inflation has not picked up given the enormous expansion of the Fed’s balance sheet since the advent of QE. First in the traditional profile of Fed implementing monetary policy as you described, an increase in reserves translated into an increase in lending by commercial banks - leading to economic expansion, wage growth, and, ultimately, inflationary pressures. This highly correlated ( if not causal) response to increased bank reserves continued given the underlying assumption that increased reserves led to commercial banks having the desire and now ability to expand their balance sheets with loans. The money multiplier effect, essentially. However, bank reserves, in and of themselves, do nothing for the economy as the Fed is where money goes to die. Cash and reserves at the Fed are not in the economy. Traditionally then bank reserves levels and changes in those levels at the Fed were an indicator of anticipated increase in lending. The concept of “the Fed is where money goes to die” is important if not critical toward understanding today’s “inflation puzzle.”
Because the Fed now pays interest on reserves, though only a small amount, commercial banks have a risk free alternative to lending in the market. As you mention the Fed’s balance sheet has expanded enormously since QE. However, the preponderance of that expansion has been in excess bank reserves; essentially dead money from the economy’s perspective. No money multiplier effect. Indeed since 2005 seasonally adjusted M1 has grown at a relatively modest average annual rate of 7.87% and seasonally adjusted M2 at an average annual rate of 5.98%. (Fed’s H-6 report) Apparently not strong enough growth in the M’s to stoke core inflation. Another perhaps unintended consequence to paying interest on excess reserves will become evident when the Fed decides to increase short rates. Once short rates exceed what the Fed pays those excess reserves become an opportunity cost to commercial banks. Instead of reducing accommodation the fed could well see a massive increase in the M’s as commercial banks reduce excess reserves in pursuit of higher risk adjusted returns in C&I loans. In the Fed’s desire to return to normalcy perhaps the first move is to reduce the interest rate on excess reserves to market or below market levels and see how fast excess reserves leaves the Fed and adjust accordingly at that time.
As I mention I would be most interested in your take on my comments.

http://prosyn.org/tN2qEb9;

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