The Fed may choose to live with higher inflation
Milton Friedman once said that monetary policy affected the economy with a lag that is “long and variable”. In other words, economics was (and still is) an inexact “science” and “we don’t really know” sounded too imprecise. The empirical finding is that monetary policy tends to have roughly twice the impact on growth as it does on inflation and the hit to output often occurs first. A sample of these findings is shown below*.
Standardized to a 1ppt increase in rates; some data is approximated
Some methods take a more granular approach to measuring the impact. Jarocinski, et al use high-frequency data following decisions by the Federal Reserve. This suggests larger coefficients on both growth and inflation, but again the magnitude is much larger for output than inflation (about two times). The same conclusion is reached for the European Union.
“Deconstructing Monetary Policy Surprises— The Role of Information Shocks” Marek Jarocinski and Peter Karadi
“Information effects of euro area monetary policy: New evidence from high-frequency futures data”. Mark Kerssenfischer
Combining interest rate hikes and changes to the Fed balance sheet, a cumulative level of c. 525bps of tightening is currently expected in the United States. This is probably sufficient to induce a recession in the United States but probably only enough to bring inflation down to the 3-4% range using the current trimmed-mean CPI level of c. 6%.
What are the first order implications? Breakeven rates implied by longer-run TIPS are probably still too low. And tightening in Asia and some parts of Europe exceeds the level required to bring underlying inflation rates back to normal levels.
Author’s calculations; IMF, St Louis Fed and country statistics offices
Second order?
Over time, currency weakness in countries with muted underlying inflation pressures (e.g. Japan, Korea, Taiwan and to an extent Switzerland) may be accompanied by those countries selling USD and buying local currency. Why should they import inflation through currency weakness or raise nominal interest rates to extinguish inflation pressures that are at reasonable levels? This puts the Bank of Japan meeting next week into heightened relief. It is somewhat awkward for the BoJ that a majority of firms support a stronger JPY. If foreigners became net sellers of USTs (to combat currency weakness and imported inflation) on a scale similar to their accumulation in the early 2000’s, it would suggest a further 50bps increase in UST yields is possible.
Appendix:
* NB that these findings have been replicated in the UK, Canada, Australia, Sweden, etc with similar results.
Laurence Ball and Dean Croushore. “Expectations and the Effects of Monetary Policy”. November 1995
Jean Boivin, Michael T Kiley, Frederick S Mishkin. “How has the Monetary Transmission Mechanism Evolved Over Time?”. April 2010.
Ben S. Bernanke, Ilian Mihov. “Measuring Monetary Policy”. August 1998.
Oscar Jorda, Moritz Shularick, Alan M Taylor. “The Effects of Quasi-Random Monetary Experiments”. November 2017.