Inflation Dynamics under the Loop

There obviously exists a huge bulk of research papers and articles on the role, drivers, and anatomy of inflation in the economy and if you were to take on this subject it might be difficult to know where to start although of course the theoretical schools discussing different inflation dynamics are included in the major gravitational core of the economics profession (e.g. Keynesianism and Monetarism). However, a good place to start (after the textbook theory is firmly in place) is a recent speech by Federal Reserve governor Frederic Mishkin on inflation dynamics in the US (and to some extent beyond. I particularly think the piece is nice in relation to applied economics studies where of course the nitty gritty of (potentially) changing inflation dynamics is important. Interestingly, the idea that inflation persistence today is relatively subdued after a shock to the economy compared to the past relates closely to the topic I recently noted on the recovery of the economy iteself (i.e. growth) on the back of an external shock in the form of for example a financial crisis.

Mark Thoma has an excellent summary as always with an interesting comment section to follow as well as Brad De Long also notes the piece. I recommend you to read the whole piece but do pay attention to Mishkin's conclusion that the change in inflation dynamics is the result of how expectations are better anchored which is to say that inflation is more likely to converge on a trend level consistent with long run expectations. Here is the intro from Mishkin's speech:

Under its dual mandate, the Federal Reserve seeks to promote both price stability and maximum sustainable employment.[1] For this reason, we at the Federal Reserve are acutely interested in the inflation process, both to better understand the past and--given the inherent lags with which monetary policy affects the economy--to try to forecast the future. We economists have made some important strides in our understanding of inflation dynamics in recent years. To be sure, substantial gaps in our knowledge remain, and forecasting is still a famously imprecise task, but our increased understanding offers the hope that central banks will be able to continue and perhaps even improve upon their successful performance of recent years.

Today, I will outline what I see as the key stylized facts that research has in recent years uncovered about changes in the dynamics of inflation and will present my view of how to interpret these findings. The interpretation has important implications for how we should think about the conduct of monetary policy and what we think might happen to inflation over the next couple of years. I will address these two issues in the final part of the talk.

Update on Monday, March 26, 2007 at 02:55PM by CV

The always readable Krishna Guha from the FT also has an article on Mishkin's piece in today's issue (25th of March) of the FT. Krishna relates the speech to Fed policy and more specifically inflation targeting and the idea of just how far down inflation should go according to the FOMC in the light of Mishkin's discoveries that inflation seems less persistent to be entrenched than before.

The Federal Reserve would have to think twice before trying to push inflation below 2 per cent, governor Frederic Mishkin has warned, in an explosive speech that is likely to unleash a fierce debate as to what the US central bank’s inflation objective is and should be.

The speech challenges the market’s belief that the Fed sets policy with the intention of returning inflation to a “comfort zone” of 1-2 per cent as measured by the core personal consumption expenditure (PCE) deflator.

It raises the possibility that some members of the interest rate-setting Federal Open Market Committee could be willing to settle for bringing core PCE – which is currently running at an annual rate of 2.25 per cent – down to about 2 per cent.

Mr Mishkin suggested it should not be too difficult to get inflation back to that level, given the pull of entrenched inflation expectations.