Good reads

This paper by Christiano, Ilut, Motto and Rostagno from last year's Symposium (back when Fed economists seemed to care about whether they could do anything to help pull the world out of recession) is very interesting. Cliffs Notes version: Contrary to conventional wisdom, stock market booms are generally associated with low inflation. This is because anticipated increases in productivity which fuel stock market booms (think the internet bubble) also imply reduction in costs for producers, meaning lower future inflation. Forward-looking price-setters will put off price increases or cut prices today in anticipation of lower future prices. If the Federal Reserve conducts monetary policy using an inflation target (as is its current practice), it will lower interest rates when it sees inflation fall. This causes the economy to accelerate and exacerbates the stock market boom, destabilizing the economy. Instead the Fed should raise interest rates when expected productivity increases spark stock market booms. The optimal policy can be approximated by including a measure of credit in the Federal Reserve's monetary policy reaction function (that is, the Fed raises rates when unemployment falls, inflation rises, or total credit rises). Christiano et al. demonstrate this elegantly in a standard New Keynesian model.



Paul Krugman and others are skeptical that inflation could ever be a problem with the economy in as deep a recession as we currently are, and therefore are very critical of the Federal Reserve's reluctance to get more expansionary in light of recent increases in inflation. The Christiano et al. paper sheds a little light on this argument. Flip the paper's logic around. An anticipated decrease in productivity - could be due to anything, but let's say concerns about excessive government regulation, higher taxes, or deterioration of skills among the long-term unemployed - causes asset prices to fall. It also causes firms to anticipate higher inflation in the future. They therefore start increasing prices now, causing inflation to rise. Boom - standard economic theory (which one should acknowledge Krugman is not wild about) suggests you can have inflation even during a deep recession.



However, standard economic theory, articulated in Christiano et al., also says that the Fed should lower, not raise interest rates in response to this upward pressure on inflation. The Fed should be setting the market interest rate to track the natural rate, which falls when productivity falls. Krugman's wrong that there is no coherent argument that inflation can rise during a severe recession, but correct in his criticism of the Fed's monetary policy.