The Fed should be careful what it wishes for

Empirical relationships in economics are sufficiently fragile that thereis even a “law” about their failure. As British economist CharlesGoodhart explained in the 1980s, “any observed statistical regularitywill tend to collapse once pressure is placed upon it for controlpurposes.” Central banks in advanced economies have recently beenproviding a few more case studies confirming Goodhart’s Law, as theystruggle to fulfil their promises to raise inflation to the stableplateau of their numerical targets.Major central banks’ fixation on inflation betrays a guilty consciencefor serially falling short of their targets. It also raises the riskthat 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 of2012 quantified its Congressional mandate of “promoting maximumemployment, stable prices, and moderate long-term interest rates.” Thesegoals would be best achieved by keeping inflation, measured by theFed’s preferred personal consumption price index, at 2% in the long run.Since then, the four-quarter growth in that index has been below thistarget in every quarter but one, as Fed forecasts of inflationconsistently 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 Januarymeeting of the Federal Open Market Committee (FOMC) reveal an extensivediscussion among policymakers about how to determine US inflation. Morethan a thousand words (an enormous footprint in a normally succinctdocument) were required to summarise three separate staff briefings onthe subject. Readers learned of alternative approaches to forecastinginflation, of the prevailing low level of inflation expectations, and ofthe diminished pressure that resource slack places on costs (or a lessreliable Phillips’ curve). Fed officials wrung their hands about missingthe 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 hasbeen getting wrong. The description of its efforts to determineinflation, with its blinkered focus on the domestic economy, is athrowback to the 1960s. Nowhere among those thousand words were thephrases “trading partners,” “the foreign exchange value of the dollar,”“commodity prices,” or “global supply chains” to be found. But the restof the world economy exists, is bigger than it once was, and acts lesslike the US than it once did. All of this implies a discipline on costsin a sluggish economy and a potential accelerant in an overheated one.As for the first observation, total US exports and imports of goods andservices relative to nominal GDP (the standard international measure ofopenness to trade) currently stands at close to 30%. This is more thanthree times its average in the 40 years prior to the break-up of themanaged fixed-exchange rate system, when the Phillips’ curve yieldedmore robust guidance. The rest of the world exists. Second, while the US economy remains the largest in the world by mostmeasures, comprising one-quarter of global GDP, this share is tenpercentage points lower than in the 1960s, when US factories producedthe most steel, autos, and aircraft in the world. Low transport andcommunications costs and freer trade have knitted markets more closelytogether, implying that this relative decline in the US share of theglobal economy loosens the link between domestic capacity constraintsand international pricing. The rest of the world is bigger.Third, early in the post-Bretton-Woods era, US trade was predominantlywith the “Old World” of Europe, Canada, and Japan. Based on bilateraltrade shares, transactions with Asian and Latin American economiescaught up by 2006, and their relative trade significance for the US hasmore than doubled since 1972. While over-generalisations are risky, these other important tradingpartners have relatively larger pools of lower-wage workers to draw uponand discipline costs along the global value chain. The rest of theworld is not entirely like the US.These observations may explain why costs are sticky on the way up; butthey do not imply that costs are stuck forever. With the US unemploymentrate close to 4% and headed lower this year, inflation will move up,though less than the long-term record predicts. Fortunately, Fedofficials are aware of the role of resource slack in driving inflation,with the January minutes noting that “estimates of the strength of thoseeffects had diminished noticeably in recent years.”The discussion, however, would have been more reassuring if it hadincluded the rest of the world, in part because doing so will continueto pose a critical challenge for policymakers. A more trade-relianteconomy is more sensitive to fluctuations in the foreign exchange valueof its currency.True, much of global trade is invoiced in dollars, but the Chineserenminbi is muscling into that turf, and producers ultimately care abouthow their revenues translate into domestic purchasing power. The upsiderisk to US inflation stems from that translation – the value of thedollar.The legislative one-two punch of tax reform and spending increases putsthe US federal debt on an upward path. If fiscal laxity tarnishes thesafe-haven status of Treasury securities, and the monetary authority isperceived to be slow in removing policy accommodation, Fed Chair JeromePowell and his colleagues may get more of the inflation they are hopingfor. – Project Syndicate* Carmen Reinhart is Professor of the International Financial System atHarvard Kennedy School. Vincent Reinhart is Chief Economist and MacroStrategist at BNY Mellon Asset Management North America.