The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.

Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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August 24, 2006

Mostly Good Sense...

... from Arthur Laffer, writing in the opinion page of today's Wall Street Journal. First, what could be read as an implicit defense of core inflation measures:

Prices of goods in fixed supply do tend to rise relative to all prices as the global economy accelerates. In the short run, increases in demand for products in relatively fixed supply result in higher prices rather than more output. And, of course, those products that are typically in fixed supply include commodities such as oil, gold, copper and agricultural products. But to confuse an increase in commodity prices with general inflation is a serious mistake...

In my own comments on core inflation I have emphasized the apparent superiority of core measures in forecasting future headline inflation (here and here, for example).  But it is also true, as Dr. Laffer implies, that temporary accelerations in inflation generated by fluctuations in particular relative prices are just not all that bothersome, as long as they do not translate into an ongoing increase in the growth rate of prices more generally.  Bothersome from the point of view of economic conditions that a central bank can genuinely affect, that is.  Increases in the price of oil relative to all other goods and services are certainly costly, but fixing that problem is outside central bankers' sphere of influence.   

It is true that it is within the power of monetary policy to lower the level prices on average, thus neutralizing the impact of rising commodity prices on headline inflation rates.  But this will not change the fact of those commodity prices rising relative to all other prices, would do nothing alleviate the pain associated with those relative price increases, and may well exacerbate disruptions in the short run if the monetary policy course is excessively tight at precisely the time the commodity-price shocks are themselves tending to weaken the economy.

I do have a few quibbles.  Although I always appreciate perspective in discussions of the dollar's value in exchange for foreign currencies...

With today's U.S. global capital surplus (i.e., trade deficit) equaling almost 6% of U.S. GDP -- an all-time high -- it's only natural that with improving economic conditions abroad, global investors would allocate more of their assets to foreign investments. Hence, the decline in the dollar. Over the years we've seen this type of currency move time and again.

... I suspect the emphasis on specific tax policies...

From 1978 to 1985, the foreign exchange value of the dollar doubled in response to the tax cuts and sound money of Ronald Reagan and Paul Volcker; then, from 1985 to 1993, with the end of the Reagan era and George Bush's and Bill Clinton's original tax increases, it halved back to about where it was in 1978; finally, from 1993 through 2002, the dollar once again appreciated back to its former highs because of the great economics of Presidents Bill Clinton and George W. Bush.   

... draws things a little too finely.  (Did I miss those tax cuts in the last half of the 90s?)  I also think that this statement, which opens the article, is too strong:

You'd have to dig pretty far down in the duffle bag of economists to find one who actually believes in the Philips Curve-- the idea that rapid growth causes inflation.

In fact, most economists agree that there is no long-run tradeoff between inflation and output.  But the notion of a short-run Phillips curve, with the embedded idea that inflation falls when GDP falls below its potential, is very much the conventional wisdom.  (This book, by economist Michael Woodford, is the bible of current orthodoxy, although, like the real Bible, there are probably more people who adhere to its tenants than who have actually read it.) 

Still, the unrepentant monetarist in me can't help but applaud this statement:

In truth, rapid growth in conjunction with restrained monetary base growth is a surefire prescription for stable low inflation. The old saw that too much money chasing too few goods results in inflation couldn't be more accurate.

Well said.

UPDATE: In the comment section, Mike Woodford -- yes, that Mike Woodford -- defends Laffer's comment about the Philips curve, noting that economists no longer believe that growth is inflationary per se.  Since that is one of Dave's 5 Essential Macroeconomic Truths, I would be hard-pressed to disagree.  And, in fact, I did take pains to say "inflation falls when GDP falls below its potential", emphasis added this time. But to me that is pretty much the old Philips curve idea.  The main difference between thinking now and thinking back in the day is that our view of "potential" is more sophisticated, drawing as it does on the ideas of real business cycle theory channeled through the Mike's good (and enormously influential) work.  But as long as we replace "the idea that rapid growth causes inflation" with "the idea that rapid growth that drives GDP above its potential causes inflation", it seems to me the Philips curve notion survives. If that is what Dr. Laffer had in mind, I retract my statement. 

knzn has some thoughts on this. So does Donald Luskin.

UPDATE: Gabriel Mihalache has more thoughts on the topic. (And to answer Gabriel's question, Lucas' famous "island model" -- in his 1972 JET article "Expectations and the neutrality of money" -- is indeed a Philips curve model.)

August 24, 2006 in Exchange Rates and the Dollar , Federal Reserve and Monetary Policy , Inflation | Permalink


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» Ye'Olde Phillips Curve from Economic Investigations
Arthur Laffer made some weird and vague statements in his WSJ.com commentary regarding the quality of economics who still use the Phillips curve: Youd have to dig pretty far down in the duffle bag of economists to find one who actually believes ... [Read More]

Tracked on Aug 25, 2006 4:26:03 PM


On the other hand from 1978 to 1985 the spread between us bond yields and the average bond yield of Germany, Japan and the UK rose from -0.6 to + 4.85 before returning to negative levels in 1993. From 1993 to 2000 the strong dollar was also accompanied by strongly rising international interest rate spreads. While far from perfect, the swings in interest rate spreads appears to explain the swings in the dollar much better then the factors he claims.

Or to put it another way the dollar did a round trip from 1978 to 1988 but the policies he cites did not do a round trip over that period that coincided with the dollar moves.

On the other hand capacity utilization leads inflation and total inflation leads core inflation.

Posted by: spencer | August 24, 2006 at 10:53 AM

Laffer is right that few macroeconomists now believe in the doctrine that he refers to as "the Phillips curve" --- the doctrine that high growth as such is inflationary. Growth that is in line with growth in the economy's potential (or "natural rate" of output) is not inflationary. The sense in which the idea of a Phillips curve is still correct is that growth in excess of the natural rate, owing to monetary stimulus, creates incentives to raise prices faster.
But (and this is presumably Laffer's main concern) supply-side measures that increase the natural rate of output are not inflationary. An important virtue of the modern (micro-founded) theory of the Phillips curve is that it shows both the effects of supply-side measures on the economy's natural rate and the way
in which monetary stimulus can lead to output in excess of the natural rate and accordingly to inflation --- one need no longer think only about one of these possibilities or the other.

Posted by: Mike Woodford | August 24, 2006 at 02:04 PM

How ARE unrepentant monetarists defining "restrained monetary base growth" these days?

Posted by: bailey | August 24, 2006 at 02:29 PM

Mike. Take a look at what the other vowelness economist - knzn - had to say about that paragraph re the Phillips curve. Simply put - Laffer does not know the difference between SHIFTS OF a curve V. SHIFTS ALONG a curve.

Posted by: pgl | August 24, 2006 at 03:39 PM

bailey -- You kind of caught me on that one. By "unrepentant" I mean that I think money matters, and that it is still throught the provision of liquidity that the central bank moves the price level. The pity is, of course, I have no idea what the mapping from monetary base to inflation looks like these days. I don't repent, but I do regret that my monetarism is these days pretty much a matter of faith.

Posted by: Dave Altig | August 24, 2006 at 06:00 PM

Oh my - Donald Luskin criticizes Art Laffer on economics and Luskin gets the better of it.

Posted by: pgl | August 24, 2006 at 10:23 PM

Oil prices or other commodity prices are not more outside the influence of central banks than other prices. In fact, they are arguably more easily influenced by central bank actions than other prices simply because they are traded on financial markets and thus move easily, whereas most prices of services and finished goods are far more rigid.

This means that commodity prices will be the first to feel the effect from central bank actions and will more fully reflect them.

Sure there are other factors than those from the central bank that affect commodity prices, but that goes for all other prices as well.

Posted by: Stefan Karlsson | August 25, 2006 at 12:11 PM

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Posted by: Alena | August 27, 2006 at 05:11 PM

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