In the past, I’ve argued that our overly respectful view of central bankers has led us to misdiagnose recessions. Indeed it has led us to distort macroeconomic theory.

In basic macro theory, the path of NGDP is determined by monetary policy. Recessions occur when NGDP growth falls suddenly and unexpectedly. Thus it seems logical to assume that whenever there’s a demand-side recession it is the Fed’s fault.

The profession greatly respects people like Bernanke, Yellen, and Draghi, as they should. These are talented central bankers. But we should not let that well deserved respect influence the way we think the macroeconomy works. Unfortunately, that’s exactly what we do.

The Economist recently did a long article on the mystery of low inflation. Overall it’s a good article, well worth reading. But there are a few problem areas.  Here’s one:

Later in the decade, amid low unemployment rates, monetary policymakers became more attuned to the risk of overheating. It would be odd, however, to explain low inflation by appealing solely to deliberate choices on the part of central banks, when they themselves profess to be confused by inflation’s quiescence.

A bus is driving from Los Angeles to Vegas. At some point, the bus goes off course and ends up in the Mojave Desert, 20 miles from I-15. The bus driver’s labor union points out that this is a skilled driver. “It would be odd to attribute the location of the bus to choices made by the bus driver. More likely, an electromagnetic pulse from outer space affected the bus’s navigation system.” How would that excuse work?

Think about it. The Fed raised rates 9 times. Each rate increase was done with the intention of preventing inflation from overshooting the Fed’s 2% target.  They relied on a flawed Phillips Curve model that predicted that low unemployment would cause high inflation.

Yes, “they themselves profess to be confused”. I’m sure the errant bus driver was also confused. But is this any reason to absolve them from making bad decisions? Why wouldn’t you blame low inflation on the choices of the central bank?

Not all central banks have trouble hitting their 2% inflation target.  In the UK, inflation has averaged 2.06% over the past decade. If you insist on excluding the last three years (when inflation was boosted by the Brexit depreciation of the pound), it’s 1.97%. If you take the past 20 years, it’s 2.02%.

The Economist piece also has a long discussion of how supply-side factors might have played a role in low rates of measured inflation. Unfortunately, the evidence suggests that this is wrong. Technological innovations such as the “Amazon effect” can only reduce inflation to the extent that they boost productivity growth. But productivity growth has been slower since 2004. Thus the data do not provide even a necessary condition for considering the hypothesis that productivity gains (or any other supply-side factors, such as trade with China) is holding down inflation. James Pethokoukis has a cute tweet:

PS. Even if technological progress were rapid, it would not hold down measured inflation, due to monetary offset. At best, it might reduce actual inflation if the rate of progress were underestimated.

PPS. The article ends up endorsing NGDP targeting, and there are other good parts as well.

HT: David Beckworth