Sunday, April 7, 2013

Inflation Targeting, Oil, and the Great Recession

In my view, an important cause of the Great Recession is the practice of the Fed and other cdentral banks of targeting consumer price inflation.

The rapid economic development in China and India in recent years has resulted an increase in the relative price of oil.   The growing Chinese and Indian middle classes are buying and driving cars and so buying and using gasoline.

Developed oil importing countries, especially Japan and Europe, but also the U.S., face increasing oil prices.   This results in higher gasoline prices, which raises the consumer price level.  

While inflation-targeting central banks often look at measures of "core inflation," they do so because of the large volatility in energy and food prices.    The prospective development of the Chinese and Indian economies are not matters of volatility, but rather a long term trend of rising relative energy prices.

To keep consumer inflation on target, other prices must rise more slowly to offset the rising relative price of energy.    Perhaps most importantly, money wages must grow more slowly as well.   This is essential to maintain full employment while slowing  the rise in the prices of domestically produced consumer goods and services.    It reflects the slower growth in real incomes in developed countries implied by the increasing relative price of imported oil.

Further, if employer compensation plans create a large element of inertia in the growth path of wages, then the level of wages can rise substantially above the long term growth path.   This can be corrected by an immediate drop in wages.   If the actual impact of high unemployment is just a gradual slowing of wage rate growth, shifting wages to a lower growth path will require wages growing even more slowly than the long run trend (already slower) for a substantial period of time. 

Of course, if the increase in the relative price of oil is large enough, then the equilibrium growth rate for real wages in developed countries could be negative for a substantial period of time.    (Once India and China have completed their "catch-up" growth phase, and have incomes similar to those in the developed world, then this process will be complete.)

However, because oil can be stored, and more importantly, left in the ground in anticipate of price increases, the price of oil does not smoothly adjust with growing demand in China and India. The expected growth in energy demand results in a large immediate changes in the current price oil.

This suggests that even if the trend equilibrium growth rate in real and nominal wages in developed countries would remain positive, the actual adjustment process would be a large sudden drop in real wages and then a  return to growing wages at something close to the previous trend.   With consumer price inflation targeting, this would require a rapid large decrease in money wages.    Again, if  money wages actually have inertia on the current growth path, and only adjust by a slower growth rate, then the need to adjust to a much lower growth path for real wages would suggest a much longer period of high unemployment as the below long term trend growth rate in money wages very gradually allows equilibrium wages, growing along the lower growth path, to catch up.

To the degree that China and India depend on exports to developed countries for their growth, then the recession in developed countries caused by inflation targeting would slow economic growth and so the growth of energy demand.    This will tend to lower energy prices in the world, and so dampen and even partially reverse the decrease in the equilibrium growth path of wages.    This should dampen the recession in the developed world.

With nominal GDP level targeting, the process is much different.   Wage rates in developed countries, especially Japan and Europe, can remain on an unchanged growth path.   The price of imported oil increases, and so do consumer energy prices.   The CPI and other measures of consumer prices rise more rapidly.   Real wages in developed countries, along with other real incomes, grow more slowly or even fall.

However, lower real incomes in developed countries is going to adversely impact imports from countries like China and India.  This would dampen the growth in China and India and so the prospective demand for energy there.   However, the result would be a dampening of the CPI inflation in developed countries rather than reducing the depth of recession.

With inflation targeting, a sudden, unexpected increase in the inflation rate, and so the price level, is ignored.   To some degree, the fact that current oil prices involve a forecast of future demand allows some of the impact on measures of consumer price inflation to be ignored.     Unfortunately, to the degree that this process can be predicted, a central bank that is targeting expected future inflation should force the economy into a recession so that the growth path of equilibrium money wages will be forced down with real wages.  

Would central bankers describe this process as worrying about inflation expectations becoming unanchored?     Is it any accident that it was just that concern by central bankers in 2008 occurred right before a modest recession turned into a disaster?

I don't think so.

End inflation targeting now.

Or....   start calling for massive cuts in money wages.


  1. i liked this post every much.

    Back in 2008, I was pulling out my hair (and I am bald) that people were jibber-jabberign about gold and oil, and that the Fed was causing inflation.

    Of all the commodities in the world, probably gold and oil have the least to do with Fed policy. Sheesh, Indians and Chinese are the largest buyers of gold, and they have growing middle and upper classes (we are talking nearly 2.5 billion people) . Moreover, Indians buy gold to avoid taxes, Chinese for traditional gift giving.

    As pointed out, oil is funny one, inelastic demand and supply in the short run, and spooky goings on on the NYMEX. Many nations that could pump way more oil---Iran, Iraq, Nigeria, Mexico, Venezuela, Russia---are thug nations, no real rule of law or free enterprise. Even Saudi Arabia limits drilling.

    Despite all that, the price signal works. Demand is flat and supplies rising. We may in fact have hit Peak Demand for crude oil. It has been falling for 30 years in japan and Europe and now in the USA also.

    This hysteria about oil and gold goes back to a peevish fixation on price stability as the only moral policy choice.

    I agree with this excellent blog post. If we have central banks, they must target NGDP growth and let inflation fall where it may, though in practice that will be under 6-7 percent.

  2. Bill, good stuff as usual.

    So would you say that the problem is that we have a commodity bundle medium-of-account in which the dominant bundle is energy? That our CPI standard is basically an oil standard, just like the old gold standard?

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