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Ben Bernanke (2008), Don Kohn (2008), Fredric Mishkin (2007), Randall Kroszner (2007) and Charles Plosser (2007) all have made statements to the effect that the credit, MEW or collateral channel through which house prices affect consumer demand is on top of the normal (pure) wealth effect. This is incorrect. The benchmark should be that the credit, MEW or collateral effect is instead of the normal (pure) wealth effect. By overestimating the contractionary effect on consumer demand of the decline in house prices, the Fed may have been induced to cut rates too fast and too far.
There are channels other than private consumption through which a change in house prices affects aggregate demand. One obvious and empirically important one is household investment, including residential construction. A reduction in house prices that reflects the bursting of a bubble rather than a lower fundamental value of the property also produces a pure wealth effect (Buiter (2008b,c)). My criticism of the Fed’s overestimation of the effect of house price changes on aggregate demand relates only to the pure wealth effect on consumption demand, not to the ‘Tobin’s q’ effect of house prices on residential construction.
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I assume that the price stability leg of the Fed’s mandate refers to price stability, now and in the future, defined in terms of a representative basket of consumer goods and services that tries to approximate the cost of living of some mythical representative American. It is well-known that price stability, even in terms an ideal cost of living index, cannot be derived as an implication of standard microeconomic efficiency arguments. The Friedman rule gives you a zero pecuniary opportunity cost of holding cash balances as (one of) the optimality criteria, that is, i=iM. When cash bears a zero rate of interest, this gives us a zero risk-free nominal interest rate as (part of) the optimal monetary rule. With a positive real interest rate, this gives us a negative optimal rate of inflation for consumer prices, something even the ECB is not contemplating.
Menu costs imply the desirability of minimising price changes for those goods and services for which menu costs are highest. Presumably this would call for stabilisation of money wages, since the cost of wage negotiations is likely to exceed that of most other forms of price setting. With positive labour productivity growth, a zero money wage inflation target would give us a negative optimal rate of producer price inflation.
New-Keynesian sticky price models of the Calvo-Woodford variety yield (in their simplest form) two distinct optimal inflation criteria, one for consumer prices and one for producer prices. Neither implies that stability of the sticky price sub-index is optimal.
Equations (15) and (16) below show the log-linear approximation at the deterministic steady state of the (negative of the) social welfare function (which equals the utility function of the representative household) and of the New-Keynesian Phillips curve in the simple sticky-price Woodford-Calvo model, when the natural rate is efficient (see Calvo (1983), Woodford (2003) and Buiter (2004)).
( ) ( )
(
2 2 2)
0
1 ˆ ( )
1
0, 0, 0
i
M
t t t i t i t i t i t j t j
i
E π π ω y y φ i i
δ
δ ω φ
∞
+ + + + + +
=
Λ = − + − + −
+
> > ≥
∑
ɶ(15)
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(
1 1)
( ˆ ) ( )0 1; 0
M
t t Et t t yt yt it it
π π β π π γ ϕ
β γ
+ +
− = − + − + −
< < >
ɶ ɶ
(16) In the Calvo model of staggered overlapping price setting, in each period, a randomly selected fraction of the population of monopolistically competitive firms sets prices optimally. The remainder follows a simple rule of thumb or heuristic for its price. The inflation rate chosen by the constrained price setters in period t is πɶt. Optimality in this model requires
M
t t
i =i (17)
t t
π π= ɶ (18)
Equations (17) and (18) then imply that yt = yˆt.
The requirement in (17) that the pecuniary opportunity cost of holding cash be zero is Friedman’s misnamed Optimal Quantity of Money rule. The second optimality condition, given in (18), requires that the headline producer price inflation rate, π, be the same as the inflation rate of the constrained price setters, πɶ. If in any given period the inflation rate of the constrained price setters is predetermined, then the second optimality requirement becomes the requirement that overall producer price inflation accommodates the inflation rate set by the constrained price setters, whatever this happens to be. Even if one identifies the inflation rate set by the constrained price setters with ‘core’ inflation (which would be a stretch), this New-Keynesian framework does not generate an optimal rate of inflation either for core inflation or for headline inflation. All it prescribes is a constant relative price of core to non-core goods and services.
Without luck or additional instruments (such as indirect taxes and subsidies driving a wedge between consumer and producer prices) it will not in general be possible to satisfy both the Friedman rule and the constant relative price rule (of free and constrained price setters). How then can this framework be used to rationalise (a) targeting Woodford-Calvo
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‘core’ inflation and (b) aiming for stability of the Woodford-Calvo ‘core’ producer price level? Two steps are required. First, the Friedman rule is finessed or ignored. This requires either the counterfactual assumption that the interest rate on cash is not constrained to equal zero but can instead be set equal at all times to the interest rate on non-cash financial instruments (that is, (17) always holds, but i remains free), or the assumption that the technology and preferences in this economy take the rarefied form required to make the demand for cash independent of its opportunity cost, in which case φ ϕ= =0. Second, the Woodford-Calvo ‘core’ inflation rate, which plays the role of target inflation rate in the social welfare function (15) is zero. This is the assumption Calvo made in his original paper (Calvo (1983)).
Clearly, the assumption that the constrained price setters will always keep their prices constant, regardless of the behaviour of prices and inflation in the rest of the economy is unreasonable. It assumes the absence of any kind of learning, no matter how partial and simplistic. It has strange implications, including the existence of a stable, exploitable inflation-unemployment trade-off or inflation-output gap trade-off across deterministic steady states. Calvo recognised the unpalatable properties of his unreasonable original price setting function in Calvo, Celasun and Kumhof (2007). An attractive alternative, in the spirit of John Flemming’s (1976) theory of the ‘gearing’ of inflation expectations, would be to impose as a minimal rationality requirement the assumption that the inflation rate set by the constrained price setters is cointegrated with that of the unconstrained price setters or the headline inflation rate.
Because price stability cannot be rationalised as an objective of monetary policy using standard microeconomic efficiency arguments, I fall back on legal mandate/popular consensus justifications for price stability as an objective of monetary policy. In the US, the euro area and UK, stable prices or price stability is a legally mandated objective of monetary
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policy. In the UK, the Chancellor defines the price index. It is the CPI (the harmonised version). In the euro area the ECB’s Governing Council itself chooses the index used to measure price stability. Again, it is the CPI. In the US there is no such verifiable source of legitimacy for a particular index. I therefore appeal to what I believe the public at large understands by price stability, which is a constant cost of living.
I take it as given that the Fed’s definition of price stability is to be operationalized through a representative cost of living index. This means that the Fed does not care intrinsically about core inflation (in the sense of the rate of inflation of a price index that excludes food and energy). Americans do eat, drink, drive cars, heat their homes and use air conditioning. The proper operational target implied by the price stability leg of the Fed’s mandate is therefore headline inflation.
Core inflation is relevant to the price stability leg of the Fed’s mandate to the extent that it is a superior predictor of future headline inflation, over the horizon that the Fed can influence headline inflation – a better predictor not only than headline inflation itself, but than any readily available set of predictors. After all, the monetary authority should not restrict itself to univariate predictor sets, let alone univariate predictor sets consisting of the price series itself and its components.
Non-core prices tend to be set in auction-type markets for commodities. They are flexible. Core goods and services tend to have prices that are subject to short-run Keynesian nominal rigidities. They are sticky. The core price index and its rate of inflation tend to be both less volatile and more persistent than the index of non-core prices and its rate of inflation, and also than the headline price index and its rate of inflation. However, the ratio of core to non-core prices or of the core price index to the headline price index is predictable, and so are the relative rates of inflation of the core and headline inflation indices. This is clear from Charts 6a and 6b. The phenomenon driving the increase in the ratio of headline to
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core prices in recent years is well-understood. Newly emerging market economies like China, India and Vietnam have entered the global economy as demanders of non-core commodities and as suppliers of core goods and services. This phenomenon is systematic, persistent and ongoing.