Empirical relationships in economics are sufficiently fragile that there
is even a “law” about their failure. As British economist Charles
Goodhart explained in the 1980s, “any observed statistical regularity
will tend to collapse once pressure is placed upon it for control
purposes.” Central banks in advanced economies have recently been
providing a few more case studies confirming Goodhart’s Law, as they
struggle to fulfil their promises to raise inflation to the stable
plateau of their numerical targets.
Major central banks’ fixation on inflation betrays a guilty conscience
for serially falling short of their targets. It also raises the risk
that in fighting the last war, they will be poorly prepared for the next
– the battle against too-high inflation.
Consider the United States Federal Reserve, which at the beginning of
2012 quantified its Congressional mandate of “promoting maximum
employment, stable prices, and moderate long-term interest rates.” These
goals would be best achieved by keeping inflation, measured by the
Fed’s preferred personal consumption price index, at 2% in the long run.
Since then, the four-quarter growth in that index has been below this
target in every quarter but one, as Fed forecasts of inflation
consistently fell short of the mark. Goodhart’s Law still has teeth.
The Fed’s solution to this failure, like that of other central banks,
has been to talk more about the subject. The minutes of the January
meeting of the Federal Open Market Committee (FOMC) reveal an extensive
discussion among policymakers about how to determine US inflation. More
than a thousand words (an enormous footprint in a normally succinct
document) were required to summarise three separate staff briefings on
the subject. Readers learned of alternative approaches to forecasting
inflation, of the prevailing low level of inflation expectations, and of
the diminished pressure that resource slack places on costs (or a less
reliable Phillips’ curve). Fed officials wrung their hands about missing
the target and reaffirmed their commitment to a symmetric goal of 2%
inflation in the longer run.
The summary may have inadvertently revealed part of what the Fed has
been getting wrong. The description of its efforts to determine
inflation, with its blinkered focus on the domestic economy, is a
throwback to the 1960s. Nowhere among those thousand words were the
phrases “trading partners,” “the foreign exchange value of the dollar,”
“commodity prices,” or “global supply chains” to be found. But the rest
of the world economy exists, is bigger than it once was, and acts less
like the US than it once did. All of this implies a discipline on costs
in a sluggish economy and a potential accelerant in an overheated one.
As for the first observation, total US exports and imports of goods and
services relative to nominal GDP (the standard international measure of
openness to trade) currently stands at close to 30%. This is more than
three times its average in the 40 years prior to the break-up of the
managed fixed-exchange rate system, when the Phillips’ curve yielded
more robust guidance. The rest of the world exists.
Second, while the US economy remains the largest in the world by most
measures, comprising one-quarter of global GDP, this share is ten
percentage points lower than in the 1960s, when US factories produced
the most steel, autos, and aircraft in the world. Low transport and
communications costs and freer trade have knitted markets more closely
together, implying that this relative decline in the US share of the
global economy loosens the link between domestic capacity constraints
and international pricing. The rest of the world is bigger.
Third, early in the post-Bretton-Woods era, US trade was predominantly
with the “Old World” of Europe, Canada, and Japan. Based on bilateral
trade shares, transactions with Asian and Latin American economies
caught up by 2006, and their relative trade significance for the US has
more than doubled since 1972.
While over-generalisations are risky, these other important trading
partners have relatively larger pools of lower-wage workers to draw upon
and discipline costs along the global value chain. The rest of the
world is not entirely like the US.
These observations may explain why costs are sticky on the way up; but
they do not imply that costs are stuck forever. With the US unemployment
rate close to 4% and headed lower this year, inflation will move up,
though less than the long-term record predicts. Fortunately, Fed
officials are aware of the role of resource slack in driving inflation,
with the January minutes noting that “estimates of the strength of those
effects had diminished noticeably in recent years.”
The discussion, however, would have been more reassuring if it had
included the rest of the world, in part because doing so will continue
to pose a critical challenge for policymakers. A more trade-reliant
economy is more sensitive to fluctuations in the foreign exchange value
of its currency.
True, much of global trade is invoiced in dollars, but the Chinese
renminbi is muscling into that turf, and producers ultimately care about
how their revenues translate into domestic purchasing power. The upside
risk to US inflation stems from that translation – the value of the
dollar.
The legislative one-two punch of tax reform and spending increases puts
the US federal debt on an upward path. If fiscal laxity tarnishes the
safe-haven status of Treasury securities, and the monetary authority is
perceived to be slow in removing policy accommodation, Fed Chair Jerome
Powell and his colleagues may get more of the inflation they are hoping
for. – Project Syndicate
* Carmen Reinhart is Professor of the International Financial System at
Harvard Kennedy School. Vincent Reinhart is Chief Economist and Macro
Strategist at BNY Mellon Asset Management North America.
Federal Reserve Building, Washington DC.