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Central Banking’s Fundamental Misunderstanding of Inflation

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Central banks operate under the premise that real growth is exogenous, except for policy mistakes in moderating inflation and the business cycle. The assumption is that they have dominating influence on the impulses to core inflation and the output gap, both controlled through the credit channel.

Many people since 2008 have questioned the elasticity of the output gap to the credit channel. That is not a unique criticism. The typical mechanical explanation for this has been the liquidity trap, which is a recent event, and as of the end of 2012, not relevant to a contemporary description conditions.

Central banks target core inflation, believing the highly volatile food and energy components to be subject to supply shocks, and hence exogenous to their system of control. What they are effectively doing here is taking responsibility for the sticky consumer prices (those that appear inelastic to changes in supply or demand curves), while the flexible prices are assumed beyond their scope of influence. This can be framed by observing that Sticky CPI is virtually the same as Core CPI, and Flexible CPI is, in effect, Headline CPI.

Correlation co-efficient matrix of sticky CPI, flexible CPI, core CPI, headline CPI, and the Fed Funds rate.

Correlation co-efficient matrix of sticky CPI, flexible CPI, core CPI, headline CPI, and the Fed Funds rate.

Flexible CPI is highly sensitive to changes in both supply and demand. Yes, negative supply shocks may be exogenous from Fed control, but demand is very cyclical – which is something that the Fed assumes some control over. This means that the Fed assumes that, through changes in interest rates impacting the credit channel, they can exert influence on the output gap to target sticky CPI.

This is where the argument begins to unravel.

The output gap is virtually uncorrelated with sticky CPI (-.05). It is, however, more correlated (but not particularly well correlated) with flexible CPI (-.18). Thus, it seems that:

  • The Fed can’t really control sticky CPI
  • The Fed can control flexible CPI to some degree via the credit channel on consumption and investment (demand curves), as long as the supply curve remain stable
  • Supply shocks can dominate the variation of flexible CPI

Assuming our intermediate conclusions are true, we have a Fed which ignores flexible prices, instead uses sticky prices as the primary input, but really only is able to materially impact flexible prices, and further only to the degree that there aren’t supply shocks.

We are now compelled to consider core and sticky CPIs are exogenous, making most of CPI exogenous, and limiting central bank control mostly to the spread between sticky and flexible prices.

To test our theory, we can apply impulse response function on the Fed Funds rate to Flexible less Sticky CPI. If our theory is true, it should be negative, while the impulse response of Fed Funds on Sticky CPI should be flat to positive.

Screen Shot 2016-02-28 at 2.18.49 PM Screen Shot 2016-02-28 at 2.23.30 PM

If variance in flexible prices is largely described by supply shocks, then it stands to reason that impulses on core inflation are also supply related, but are more acyclical.

This is all problematic to the assumptions under which modern monetary policy is conducted. If Fed can only effectively target the spread between flexible and sticky prices, it’s never actually addresses the underlying driver of inflation, and only exercises a much broader band of control over inflation via the output gap through rate shocks.


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