Sunday, November 20, 2005

Why the Fed Should Hide Inflation

Robert Lucas most famous idea is "rational expectations" where he argued that if people expect (for example) inflation based on some reports or policies, they will adjust prices before it happens. From the old days through to the 1960s people had built in a lag for higher production costs to trickle through the economy including higher pay, CPI etc. In the 1960s - 70s Friedman and others emphasized the "quantity" idea of inflation which pretty simply says more money = more inflation. But they didn't address the lag issue. Lucas speculated that the "verbal" basis of their theories made incorporating something like expectation too complex and so was ignored (even though the older papers acknowledged that such a thing ought to exist). So he said in his Nobel lecture.
Anyway, here's something interesting: Lucas showed that a moving average of M2 correlates very strongly with inflation. (his graph didn't show if that was adjusted for GDP. I would think it would have to be.) Unemployment (Phillips curve) on the other hand, has at best a tenuous negative corellation. More money means Inflation.
Now, last week the Fed announced they're no longer publishing M2 because it's not meaningful anymore.
Either something has happened recently that is throwing m2 off (possible. That's what the fed argues. The money/financial market effects are skewing M2 so much that it has lost its significance for policy decisions). That may be true. The fed has to make relatively short term decisions. A 10 year moving average (where the correlation shows up) is not meaningful for policy.
But...it could also be true that the Fed realizes publishing a powerful forward indicator of incipient inflation is against their interests!
It creates a rational expectation of inflation.
(Robert Lucas is considered the most influential economist of the last 30 years. Nobel in 1995. But he's not Friedman-esque. His work is Very mathematical. In fact, he's apparently responsible for making graduate economics so heavy on math. I think it's really interesting that you almost never read in the press or even most macroeconomics textbooks about dynamic -- continuously changing in time -- models of the economy vs simple static equilibrium models you always see. Partial differential equations, stochastic Markhov chains, Banach function spaces -- a bit of a jump compared to the little Supply-Demand graphs. Yet it's the dynamic models most economists take seriously these days).

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