Inflation Theories

I have been editing sections of my manuscript, and nothing out of that writing output is publishable here (since it is just a rehash of an earlier article). However, I am adding a new section on inflation theories that I will need to think about. This article summarises what I think I will cover.

My manuscript is somewhat unusual in that I am mainly discussing the “known properties” of inflation, without offering a theory of inflation. The more usual situation is that people have extremely strong views on what explains inflation (and more often than not, these views contradict “known properties” of inflation). I decided to not cover inflation theories on the basis that it somewhat difficult to get good introductory information due to the huge mass of disinformation. By avoiding theory, the manuscript statements are relatively safe to make, and so my manuscript itself hopefully stays out of the “disinformation” category.

The "Economists Monkeying With The CPI" Debate

Note: This is an unedited draft section of my inflation primer manuscript. It is is a chapter about misunderstandings/myths about the CPI. This section aims at claims that economists have fooled around with the methodology to lower the reported inflation numbers. I think one subsection was already published as a draft, but I will leave it in there. At present, I only some overview sections to write, as well as the need to take the axe to a couple sections that ended up overlapping.

A popular belief in hard money internet commentary is that economists are conspiring to lower reported inflation. The advantage of this is to mislead voters and to reduce cost-of-living adjustments paid by the government. Admittedly, there are cases in emerging markets where there is widespread skepticism about government inflation statistics, and the government inflation numbers do not appear to align with market data. As such, I label this as a “misunderstanding,” as I accept that CPI numbers probably have been fudged somewhere. However, the usual case in developed countries is that statistical agencies are transparent about their methodologies, and the complaints are bad faith misinterpretations of the methodologies.

Inflation And The Labour Market

I have been seeing comments about how labour market models have been misleading this cycle. The fun thing about this subject is how mainstream economics is supposed to be a rigorous data-driven science, yet mainstream economists are flailing around trying to come up with a relationship between two time series. (Note that this article is re-hashing points I made previously; I am too lazy to check whether I am just re-writing an old article.)

The usual response to critics who state things like I just did is “give me a better model.” The idea is that we need to replace one reductionist model with another reductionist model. The reasoning seems to be that economics is like physics, where a lot of the history of the field is doing exactly that. (Physicists might be getting into “complexity,” which may or may not be a mathematical pseudo-science. In any event, this is not what people have in mind when they compare economics to physics.) If inflation is a complicated process, any reductionist model is going to fail.

Any empirical work on the link between inflation and the labour market is going to run into a snag that is the result of what I argue are relatively non-controversial positions.

1. We assume that there exists a unitary variable that summarises the business cycle — which might not be directly measurable. It might be something like the first principal component of a few underlying variables. The usual measured variable that is supposed to be a proxy of this variable is GDP, but one may note that the NBER looks at a variety of variables to date recessions. The justification for the existence of this variable is that recessions are a somewhat nonsensical concept without the notion of some way of summarising the state of the business cycle which goes up and down. (If one wants to insist that no such unitary variable exists, we end up with business cycle nihilism. This might be the correct stance, but makes it very awkward to discuss macro.)

2. Inflation is a pro-cyclical variable, possibly with a lag. This can be justified by eyeballing inflation/GDP charts. There are any number of theoretical stories justifying why this is the case.

3. Employment growth is pro-cyclical, almost by definition. Rising unemployment is one of the defining characteristics of a recession.

4. (Core/median) inflation and employment growth empirically exhibit “trends” — although monthly data might be noisy, the averages across months tend to be smoother after seasonal adjustment (albeit with step changes during things like recession).

5. As an added bonus, we can note that private sector credit is pro-cyclical. This can be seen by eyeballing charts, and is likely to be a component of any model that takes the Kalecki Profit Equation seriously. (Neoclassical models notably do not.) Bank lending and hence deposits are a component of private credit, and thus the bank deposit component of M1 is going to be pro-cyclical.

You do not need a doctorate in statistics or need to study Real Analysis to know that 1-4 taken together imply that inflation and employment growth are going to be correlated to some possibly unknown “business cycle” variable. It is going to be nearly impossible to detect a causal relationship between the variables unless the relationship is simple and stable over time. Guess what? We cannot find any such relationship.

(The fifth point in the list is aimed at any Monetarists who for some bizarre reason decided to read this article.)

Inflation is complicated, and there is no reason to expect that rents are going to move in the same way as college tuition, used automobiles, or imported jeans. To any extent we can model inflation, we need to decompose the aggregate (which was allegedly proved to be the wrong way to look at inflation, according some neoclassical economists).

The whole “unemployment needs to rise to reduce inflation” was a terrible take since it was a somewhat innumerate understanding of a “stylised fact” about recessions. Recessions tend to be associated with disinflation (rate of inflation dropping). As such, one strategy to control inflation is to throw the economy into recession whenever inflation is “too high.” (I am not saying that is a good strategy, but reading between the lines, that is the neoliberal strategy.) However, the causal implication is one way — a recession is (typically) sufficient for disinflation, but it is not necessary (as seen in the disinflation after the pandemic spike).

Book Progress? Sigh.

I am still plugging away at editing my inflation manuscript (interrupted by the CFL Labour Day Classic). Most of the work is tweaking existing text, and thus not publishable here. However, I added a missing section that should show up within a week or so.

If I were productive, I might be able to finish it off within a month or two. Based on past experience, a publishing date in January is more realistic.

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(c) Brian Romanchuk 2023

Random PPI Observations

I am working through my inflation book manuscript, and have not had much time to think about new articles. I added a subsection on producer price indices, and decided to go use that as my latest article here. I have added extra comments that is not in the manuscript since they are tentative.

Bernanke & Blanchard Paper Comments

Ben Bernanke and Olivier Blanchard recently published “What caused the US pandemic-era inflation?” The paper creates a basic model for inflation that is fit to data, and then uses it to attempt to decompose what drove the post-pandemic inflation.

The paper argues that the bulk of the inflation spike was mainly the result of “shocks” — energy, food, and their proxy for “supply shocks.” Once the shocks subsided, inflation calmed down. The labour market heated up (as proxied by the ratio of job openings to the number of unemployed) which raised inflation somewhat, but is supposedly more persistent and thus allegedly needs to be addressed.

Sellers' Inflation

Note: this is an unedited draft from my inflation primer manuscript. It is relatively lightweight, partly because I want to avoid getting too deep into controversial theories in that book. I might add material closer to publication.

One area of controversy that showed up after 2020 was about the role of “price gouging” in the overall rise in inflation. (This idea was satirically referred to as “greedflation.”) This has been an area of theoretical dispute between post-Keynesians and mainstream economists (as post-Keynesians argued in favour of a conflict theory of inflation), although it was not that a well-known dispute until after the pandemic. The obvious reason is that most people are not going to loudly argue about the sources of inflation when it was stuck near 2%.

Since I do not want this text to stray too far into theoretical disputes, I will just outline the ideas behind this debate.

Weber and Wasner Article

Isabella M. Weber and Evan Wasner published the article “Sellers’ Inflation, Profits and Conflict: Why can Large Firms Hike Prices in an Emergency?” in 2023. The authors argue that the conventional story that inflation is always macroeconomic is incorrect, rather it can have microeconomic origins.

The abstract of the paper summarises how they saw the inflation process developing in this instance.

We review the longstanding literature on price-setting in concentrated markets and survey earnings calls and compile firm-level data to derive a three-stage heuristic of the inflationary process: (1) Rising prices in systemically significant upstream sectors due to commodity market dynamics or bottlenecks create windfall profits and provide an impulse for further price hikes. (2) To protect profit margins from rising costs, downstream sectors propagate, or in cases of temporary monopolies due to bottlenecks, amplify price pressures. (3) Labor responds by trying to fend off real wage declines in the conflict stage.

This fits within the wider literature of “conflict inflation” that characterises the post-Keynesian literature. The authors contrast this from a “macroeconomic” viewpoint, where inflation is the result of something like GDP growing above “potential GDP,” the unemployment rate being below the “The Non-Accelerating Inflation Rate of Unemployment” (NAIRU), or rapid “money” growth.

This does not correspond to “the inflation after the pandemic was the result of firms getting greedier than they were in 2019” (as some critics attempted to downplay the idea), rather it is a process that required concentration in “systemically significant upstream sectors.” There are always some firms raising prices to see whether they can pad profits, the issue is that there needs to be a mechanism for price hikes to propagate.

This idea fits in to the existing literature on “conflict inflation.” Conflict inflation is the standard post-Keynesian explanation for the inflation process. The mainstream view on conflict inflation is mixed. American neoclassical economists tend to reject the idea out of hand, while European mainstream economists were more sympathetic to the idea. The American stance tends to have a higher profile, presumably because they have stronger views on the topic.

Inflation Control Implications?

For reasons that I will discuss below, it is going to be hard to come up with conclusive analytical evidence either way on this topic if we look at outcomes under the current economic structures. The differences between the views show up more in terms of offering different policy options to combat inflation.

Given that I am not in the policy advocacy business, nor do I want to discuss unresolvable theoretical disputes in this text, I will not pursue this angle. However, the policy implications of the concept are why it matters. If one is only interested in forecasting inflation in the current policy environment, it is somewhat hard to distinguish between this concept and others.

Why I Like the Concept

I believe that the mechanism described in the Weber and Wasner article was a factor behind the inflation spike (although I will note theoretical concerns later). The authors give examples of firms taking advantage of the situation to push through price hikes, and how they fit in with the story.

The advantages of this story versus conventional theories is that we had an inflation spike at the right time.

• If one wants to blame “money printing” for inflation, why was there no inflation in Japan when they pioneered “Quantitative Easing,” or most of the major economies after 2008?

• If one wants to blame “fiscal deficits,” we then can make pretty much the same response as in the previous point.

• Trying to use the unemployment rate to explain inflation (e.g., the so-called “Non-accelerating inflation rate of unemployment (NAIRU)”) fails horribly. Inflation spiked when the unemployment rate was still quite high yet started to moderate even though the unemployment rate eventually hit low levels.

In summary, the supply chain disruptions were what distinguished the post-pandemic period from the rest of the post-1990 period, and that was the only period where inflation broke out. The supply chain disruptions were what gave “upstream firms” to ram through price hikes under this story.

Theoretical Concerns

At the time of writing, this line of argument is currently being debated, and I think the discussion will continue to shift. I have not seen an analysis that is truly conclusive one way or another.

The main difficulty is always going to be determining how much of the rise in inflation is due to rising profits. One method would be to try to estimate the effect company by company. The problem is that the ability to undertake such a survey is limited, and we need to question the reliability of things like statements on corporate earnings calls. Given that collusion to fix prices is illegal in some jurisdictions, corporate executives might shy away from stating that they did that publicly. Unless some form of survey was legally mandated to be submitted to national statistical agencies, it is going to be hard to connect anecdotal reports to the overall price index in a systematic fashion.

An alternative is that we could look at aggregate profits in the economy and attempt to assign contributions to overall price changes to the change in profits.

The previous figure shows “Corporate Profits with Inventory Valuation Adjustment (IVA) and Capital Consumption Adjustment (CCAdj)” as a percentage of national income from 2015-2022. There was an increase in the profit share after the disruptions in 2020, so one might try to argue that reflects companies padding profit margins.

The problem with this aggregate profit accounting story is the Kalecki/Levy Profit Equation. I discuss this equation in Section 4.2 of my book Recessions: Volume I. If we use a simplified version of the national accounts, the equation is:

Profits = (Net Investment) – (Household Savings) + (Dividend Payments) + (Government Fiscal Deficit) – (Net Imports).

(In the real world, the national accounts are more complicated, and there are more entries to the equation.) Importantly, this is not an opinion or theoretical model – it is an accounting identity. (An accounting identity is an equation that is true by definition – it just tells us how accounting entries add up when there are no errors in measuring the accounting entries.)

Although we could attempt to pin down the initial terms of the equation (net investment, housing savings, and dividends) by tying them to corporate pricing strategy within a model, the fiscal deficit and the trade deficit are determined by government policy and the state of the macroeconomy. Even if every firm in the economy wanted to raise its forecast profit margins, there is no guarantee that aggregate profits would rise.

An alternative way of viewing this concern is that one could create an economic model where prices and wages are constant. (For example, this describes many of the models I developed in my earlier book, An Introduction to SFC Models Using Python.) Even though profit margins on production are constant, profits in the model will still rise and fall due to other variables changing in the simulation.

Although the decomposition approach looks like the natural approach to test the theory, this is not necessarily the case. If the price hikes are being rammed through by “upstream” industries with pricing power, this results in downward pressure on the profits the “downstream” industries. Meanwhile, wages are also expected to rise.

If we move away from a “decomposition approach,” we face an additional concern: how much predictive value the concept has? It is one thing to have an explanation based on price hikes that have already happened and discussed in corporate earnings calls, it is another to have a forward-looking explanation that can be used to predict inflation. Why did we have no profit-driven inflation spikes from 1995-2020? Will we always need a disruption as large as the pandemic shutdown to have a repeat?

“Excuseflation”

We can then run into variant idea, which was dubbed “excuseflation,” which was discussed in a Bloomberg Odd Lots episode by Tracy Alloway and Joe Weisenthal ( URL in references.). Excuseflation is the observation that it is a lot easier for a firm to find an excuse to raise prices when other prices are rising. If a lot of other prices are rising markedly, it is a lot easier to sneak in price hikes that raise profit margins.

Although I think that is a good description of the psychology, we run into a theoretical problem. Saying that people are observing other prices shoot up is very hard to distinguish from those people forecasting higher inflation. This means that this is very hard to distinguish from the mainstream concept of “inflation expectations” – at least if we take a broad definition of “inflation expectations.”

Concluding Remarks

There was certainly a greater interest in the idea that price increases were the result of corporations trying to raise their profit margins after the pandemic disruptions. At the time of writing, it is still unclear whether it will shift how “mainstream” entities like central banks view inflation. My view is that it will be hard to find any data that can convincingly demonstrate an aggregate effect, although we certainly can find individual firms jacking up their prices and increasing their profitability.

The debate about the role of profit padding in inflation might result in a different perspective on how to control inflation, but that is outside the scope of this text.

References

• Weber, Isabella M., and Evan Wasner. “Sellers’ inflation, profits and conflict: why can large firms hike prices in an emergency?.” Review of Keynesian Economics 11.2 (2023): 183-213. Working paper URL: https://scholarworks.umass.edu/econ_workingpaper/343/

• “How ‘Excuseflation’ Is Keeping Prices – and Corporate Profits – High,” Bloomberg Odd Lots, Tracy Alloway and Joe Weisenthal. URL:https://www.bloomberg.com/news/articles/2023-03-09/how-excuseflation-is-keeping-prices-and-corporate-profits-high

• The most introductory text discussing conflict inflation that I own is Macroeconomics by William Mitchell, L. Randall Wray, and Martin Watts.

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(c) Brian Romanchuk 2023

Primer: The Cantillon Effect

The Cantillon Effect is the label applied to a process described in Richard Cantillon’s , «Essai sur la nature du commerce en général», published in 1755. (One English translation of the title is “An Essay on Economic Theory.”) The basic premise is that an initial inflow of money will raise prices as the original recipients of the money spend it, which will then raise other prices as the “new money” enters others’ hands.

"Greedflation" Debate

I have started writing a section for my book on the “greedflation” debate: are corporations jacking up prices to pad profit margins? Since I wanted my book to mainly focus on basic facts about inflation that are true, and not unresolved theoretical debates, it is not entirely a great fit. I was planning on publishing my draft today, but I decided to hold back and explain why that is.

Financial Markets And Inflation

Note: this is an unedited draft chapter section from my inflation manuscript. I am not too happy with this, but perhaps getting savaged on the internet might give me some additional things to add. This section follows more detailed discussions of equities and residential real estate.

We will now conclude this chapter with some general comments on the relationship between inflation and the overall financial markets. What we see is that there are some areas of direct linkage between inflation (as measured by a consumer price index) and some financial assets, other assets have a more complex relationship. As a result, making generalisations is difficult – equity prices are not going to move the same way as the prices of cheesy snacks at your local convenience store.

One Weird Trick That Neoclassical Economists Hate!

Blair Fix caused a bit of a stir last week on economics Twitter with a cleaned up version of the above chart taken from his article on interest rates and inflation. My chart is a scatter plot of the U.S. annual CPI inflation rate versus the effective funds rate, from 1954-2022. The blue line is the best linear fit of the two variables. The “linear model” suggests that inflation is an increasing function of the nominal interest rate.

Blair was met with a predictable howl of indignation on Twitter. Why predictable? The belief that higher interest rates reduce inflation (with a technical twist I note below) is pretty much enshrined as an assumption in neoclassical economics. (I use “neoclassical” as a fancy-pants word to describe “mainstream academic economics,” as “mainstream” is somewhat ambiguous if we are not referring to academia.)

Although the firestorm of indignation the article created was fun and if I had any commercial sense I would pile into it (and I did in the past). However, I have gotten more boring as I have aged. The real answer is that “things are complicated.”

Initial Complication: Real Rates

The first source of well-deserved indignation is that the above chart is a misleading representation of neoclassical theory. The driving variable in neoclassical models are real interest rates, where the “real” interest rate is the nominal interest rate minus inflation. To add to the complexity, the inflation rate is supposed to be the expected inflation rate, not the historical rate of inflation.

It is entirely correct to describe neoclassical economics as assuming that the real interest rate drives inflation. These models have at their core dynamics that are driven by households optimising their expected consumption over time, where they are trading off current consumption versus future consumption. By definition, the expected increase in nominal goods prices is expected inflation, and the pay-off for not consuming now is that households can buy “bonds” that pay the nominal interest rate. Quick math tells us that the trade-off between spot and future consumption is linked by the real interest rate. These dynamics are assumed to be true in a neoclassical model — since the presence of those dynamics is the defining characteristic of “neoclassical” models. (A mainstream academic could invent a model not of this structure, but it would not qualify as a “neoclassical model” as I define the term. This is the sort of problem that labels like “mainstream” contend with.) On paper, the model could have wacky dynamics that a real rate increase could cause higher inflation (that model would probably never be taken seriously, as it is the “wrong” answer), but the key point is that real rates are an assumed driver of economic dynamics.

From a scientific point of view, if you assume something is true and build your methodology around that assumption, your assumption is not falsifiable. (See Kalman filter discussion below if you object to that assertion.)

I generated the chart above by subtracting the annual CPI inflation rate from the (overnight) Fed Funds rate. That is, it is comparing measured inflation data on a backwards-looking basis over the past year versus the nominal return looking one day forward. Given the low quality and short time availability of expected inflation rates, I will not attempt to create a long history of real rates. For the purposes of my article, I will largely use “real rates” and “nominal rates” somewhat interchangeably, on the argument that the central bank hiking rates will tend to raise both the nominal and real policy rate, and what we are interested in in is the effect of policy rate changes on inflation.

What Do We Need To Do?

The problem with the “effect of interest rates on inflation” debate is that it is so poorly framed. Inflation is normally thought of as an “outcome” of the trends in the real economy. If interest rates have any effect on the economy, they presumably have some effect on inflation. The real question is: is there a predictable effect on inflation that allows central banks to micro-manage the inflation rate (which is what inflation targetters and their theoretical offspring insist is possible)?

In other words, we need to test particular models of the relationship between interest rates and inflation, and see whether they allow for micromanagement of the economy. Given that there is an infinite number of models that could allow for such micromanagement, it is going to be extremely hard to reject all of them. We would effectively need to find and validate a model that shows such micromanagement is impossible. That is a difficult task, with the difficulty increased by the reality that not a lot of people are looking for such models.

The Empirical Problem

I have repeatedly noted the following, but will repeat for new readers. The following observations appears to cover a lot of the observed data — call them “stylised facts.”

1. Inflation tends to rise during expansions, and will spike in response to shortages. (E.g., periodic oil price spikes, the post-pandemic price hikes.)

2. Recessions generally result in lower inflation, for the straightforward reason that a collapse in production and employment will reduce the intensity of shortages. Once the shortages are cleared out, deflationary tendencies reverse.

3. A rapid increase in nominal rates will cause stress on private sector balance sheets, and can trigger a crisis that results in a recession.

This allows monetary policy to have limited control over inflation — central banks can trigger recessions, reducing high inflation rates. This certainly does not qualify as “micromanagement of inflation rates” as claimed by neoclassical boosters of inflation-targeting central banks.

Meanwhile, empirical testing is confounded by the known ideological biases of central banks. Central bankers believe that raising real interest rates cools inflation, and cut rates rapidly in response to recessions. As such, they will increase real rates during an expansion in response to the inflation rise in point #1 above. Survivorship bias implies that real rates will peak before recessions — and plunge once the central bank is aware of the recession.

About that “Overwhelming” Empirical Literature

Neoclassicals continuously claim that they have an “overwhelming” empirical literature that demonstrates that interest rates work the way they do.

A lot of the tests are model-agnostic (I discuss the model-based ones next). Unfortunately, if we accept the stylised facts as true, they can explain almost all of the test not tied to particular models in the literature that I have seen. I cannot claim to have read every single article published in the literature, but 100% of the ones I have read were terrible. Neoclassical economists get mad when I write things like this, but if I have a 0% success rate reading a literature, I see little point in keeping reading.

As an aside, the worst part of the literature was the idea that we can read internal policy deliberations of policymakers to “prove” that interest rates work the way that neoclassicals insist. Even a slight knowledge of intellectual history tells us that closed groups believe that their shared beliefs are true, and will use those beliefs to explain events around them. By that standard, we could have elite universities handing out doctorates in haruspicy (“100,000 Romans cannot be wrong!”).

Model Based — Why Hello r*!

If we move away from model-agnostic test methods, we end up with the “neutral” interest rate — now rebranded r* — literature. Since all the standard neoclassical models predict that something like r* exists, we should see it in the observed data.

The problem is that we can reject r* being a constant, or a known simple function of other observed economic variables. So, neoclassicals assume that r* is time-varying, and estimate r* based on procedures like the Kalman Filter.

Once we strip the mathematical goobledy-gook away from the procedure, the Kalman Filter works as follows.

1. Assume the dynamic model is true.
2. Use the observed data (real interest rates, inflation, GDP growth, whatever) into a statistical procedure to estimate the “internal variables” of the model — r*, y* (“potential GDP”), etc. — so that observed data is in line with the estimated model.
3. Update the “star variables” as data comes in.

However, the issue here is that if inflation and real interest rates are autocorrelated variables (move slowly over time), we can force r* to move rapidly enough to get the model to fit the recent history. As long as the autocorrelation continues, the model will have roughly correct predictions.

And this is exactly what we saw in practice. The estimate for r* in the United States plunged after 2008 once the negative real interest rates did not result in the predicted acceleration in growth/inflation. (Yay! Secular stagnation!) The models roughly matched the sclerotic pace of economic variables during the 2010s. And one the 2020 pandemic disruptions hit, people stopped estimating the variables since the models blew up. (In technical applied mathematics terms, “lol, lmao.”)

In other words, it is very hard to falsify a model using a statistical procedure that assumes that the model is true.

Concluding Remarks

The correct answer to the “inflation-interest rate debate” is that most the “answers” being pushed are incorrect. Like other areas of heterodox-neoclassical controversy, my prediction is that pretty much the exact same points will be raised a decade from now.

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(c) Brian Romanchuk 2023

Inflation Index Calculation Basics

My upcoming inflation book continuously refers to price indices, such as the Consumer Price Index (CPI). A price index is meant to stand in for all the prices covered by the index. That is, if the index rises by 1% (e.g., going from 100 to 101), the “average” price change for the covered goods and services is 1%.

Note: This is an unedited draft from my inflation primer manuscript.

Core Inflation Woes

Alex Williams recently wrote “What Is ‘Core PCE Services Ex-Housing’ Anyway?,” which dissects the measure that the Fed is using to get a handle on “underlying” inflation. The most interesting bit (for me) is that about 1/4 of this measure is an imputed price index, based on wages. This means that this component will track wages (giving a convenient analytical relationship) by definition.

Transitoriness

The latest CPI report for the United States suggests that the inflation spike after 2020 was transitory in the rather weak sense that I understood the term “transitory.” I am curling in a bonspiel over the next few days, so I do have a long time to spend on this article, so I just want to outline my thinking on the topic of “transitory.”

The figure above shows the annual inflation rate of the durable goods component of the CPI in the United States. The spike in the inflation rate has reversed to a roughly flat annual inflation rate. This component is somewhat cherry picked, but I think it is a somewhat “clean” sub-component of the CPI. It avoids the construction lag of the housing component of the CPI, and dodges highly erratic energy prices (which we all know about).

For me, the “transitory” nature of inflation was that after the spike subsided, inflation rates would resume at a level similar to the pre-spike levels. This is different than the 1970s. We can see the spike in mid-1970s, and then the inflation rate stabilised around 5% — which was near the peak of the early 1970s. It then marched higher. The problem in the 1970s was not that inflation went up continuously, rather the underlying trend across cycles was higher.

Obviously, the people who argued that inflation would subside in late 2021 — which was a consensus view, including central bankers — were wrong. I certainly had some sympathies with their views — but I am not claiming to be a forecaster, and my view always was that there was massive uncertainty around the post-lockdown economic trajectory. The forecasting issue during the lockdown period was the uncertainty about firm failures — we dodged the massive failures that were possible. Once it was clear that those failures were not going to happen, it was not rocket science to predict that inflation would be perky given the supply chain disruptions.

However, I am not going to say that inflation is dead and buried — the labour market is still relatively tight when compared to the experience of recent decades. We still have “late cycle” inflation concerns, but the inflation prints are likely to remain closer to the rest of the post-1990s experience — and not the 1970s.

At this point, people will want to give central bankers credit for the turn around in inflation. The problem with that is that this requires some selective editing of the 1970s experience — the central bankers did raise rates, the alleged problem was that real rates were negative. Guess what? In this cycle, real rates were massively negative — at least until inflation rates reversed. Even forward nominal rates were below spot inflation, so forward real rates being positive were still predicated on an inflation reversal.

I have another draft section on the recent inflation experience (for my book) in the works, and I hope to get it out relatively soon.

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(c) Brian Romanchuk 2023

Lagging Economic Indicator Still Lagging

My feeling is that although it is too early to declare victory over high inflation rates, I think we are closing in on closer to “normal” dynamics — by the standards of the post-1990 era. I believe that there are still areas of stronger pricing power, but some of the excesses have been unwound, so that we end up with more mediocre inflation prints. At least we would if the housing component of CPI — constructed to be a very slow-moving series — settles down. The market rent series that I have seen (but I do not have access to) suggest that it will settle down, but that will be a mid-2023 story.

The chart above shows the 6-month annualised rate-of-change of the “commodities” (goods) component of the U.S. CPI. It excludes housing, and is currently near typical levels seen in past cycles. Nothing that looks like a persistent inflation problem, but we cannot completely rule out more supply chain disruptions.

My guess is that we will back to more typical dynamics, where inflation follows aggregate demand with a lag, and business cycle sentiment indicators will be the ones to watch.

This mild inflation print adds to my confidence that it makes sense to wrap up my inflation manuscript. I will not be able to definitively say that inflation will revert to its post-1990 behaviour of bouncing around its target level, but we do not see inflation marching straight up at the end of the chart, which obviously would raise questions from readers.

Crypto: A Totally Non-Surprising Surprise

Criminal charges have been laid in the “FTX Scandal,” hopefully ending a remarkably stupid news cycle. Since I respect the convention of the presumption of innocence, I will not assume that anyone involved is guilty of what they have been charged of. That said, the charges make clear that some very questionable transactions were undertaken by somebody.

I have seen a lot of second-guessing of how the authorities dealt with the situation. I have no expertise in the legal tactics, but I believe they followed the right strategy. Which was to keep crypto at the margins of the financial system, and let the frauds burn themselves out.

This strategy was costly for the small accounts who followed dreams of easy money to end up getting their crypto investments wiped out. However, that was largely inevitable. Nobody had the political capital or will to properly regulate the industry, as even central bankers ended up legitimising the industry by their embrace of central bank digital currency theorycrafting. Meanwhile, regulations would have been easily evaded — and that evasion would have been cheered on.

I see no evidence that anyone has really learned anything from recent events, as we instead see attempts of crypto supports to blame the FTX collapse on the government. Instead, the main risk to the crypto industry is cascading liquidity events as investors attempt to withdraw money. That is a fairly typical reaction to a popping bubble. The core of the crypto system can survive, but the leveraged appendages that drove up crypto asset prices are at risk.

In any event, the lack of contagion to the rest of the financial system confirms that crypto has no macroeconomic significance.

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(c) Brian Romanchuk 2022

Paper On Türkiye

I was passed a link to the paper “Exchange Rate and Inflation under Weak Monetary Policy: Turkey Verifes Theory” by Gürkaynak, Refet S. and Kısacıkoğlu, Burçin and Lee, Sang Seok. (They used Turkey, and not the apparently preferred Türkiye.) It was claimed by a well known blowhard economist to tell us something about MMT — but to be clear, that was an assertion by someone who makes a living by being wrong about macroeconomics, and not the authors of the paper. Although it has some relevance to some debates about MMT, it is a stretch to say that is telling us much that is useful.

U.S. CPI: Ouch

The CPI report in the United States was a horror show for Team Transitory. Although there were other areas with jumpy prices (e.g., food prices), I think that the housing component (above) is the part I am most concerned about in the near run.

The Incentives For Inflation "Targeting"

Now that the furore about Modern Monetary Theory (MMT) has died down (other than the continuous pathetic strawman attacks), I am seeing a downtick in economic theory arguments that I find interesting. People are arguing about the details of fiscal policy and what is happening with inflation, which end up either being political or datamining time series.

One theoretical topic that comes up is the idea of nominal GDP targeting. I have doubts about nominal GDP targeting, the main one being that it is difficult to dislodge something like an inflation target (I am not concerned with the details of the policy framework). In this article, I explain the political attractions of inflation targeting before turning to nominal GDP targeting.

On Bottom Up Inflation Analysis

I have been running into comments about “top down” versus “bottom up” inflation analysis over the years, mainly on Twitter. The usual context is a conventional economist arguing that “bottom up inflation analysis is defective” for some reason or another. I have not seen a long form analysis justifying this, rather this was drive by snark. I have seen this more often as people are taking victory laps for inflation forecasting.

Disinflation Needed A Lot Smaller Than Early 1980 Case

Marijn A. Bolhuis, Judd N. L. Cramer, and Lawrence H. Summers released a NBER working paper “Comparing Past and Present Inflation” (link) which constructs a alternate CPI index that is comparable to the present methodology. Historically, the housing component was based on house prices and included mortgage rates — which meant that the housing component of CPI mechanically follows interest rates.

US Housing Component Of CPI Not Letting Up

Unless I was interested in short-term breakevens, I viewed the consumer price index (CPI) as a lagging indicator and therefore not too exciting. As such, I am not as enthusiastic as other commentators with regards to reading the entrails of the CPI report. My interest was more in the underlying trends, and what we would expect to change. The problem with the U.S. CPI is that one of the most important “underlying” factors is housing — and the housing component has taken off like a rocket.