Is Fed’s Inflation View Built on Sand? A Staffer Suggests So, Stirring Debate About Economics

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Criticism of the Federal Reserve’s own professional ranks accused economists of making assumptions consistent with their theories.

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This is not a new criticism. This week Canadian-born economist David Card, now at the University of California, Berkeley, shared the Nobel Prize in Economic Sciences fundamental research Contrary to the textbook model of the labor market nearly three decades ago, higher minimum wages did not reduce low-wage employment.

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Mr. Card and fellow award winners Joshua Angrist and Guido Imbens were recognized for pioneering research methods, particularly “natural experiments”. These generally tease out the impact of policy interventions on the population by comparison with a similar, untreated population. Mr Card and co-author Alan Krueger, who died in 2019, compared the employment of fast-food workers in New Jersey, where the minimum wage was raised, to that in Pennsylvania, where it did not.

However, his greater legacy may be to downplay the centrality of the theory of economics. Mr. Card and Mr. Krueger noted in 2016 that at that time less than 40% of economics papers appeared in empirical analysis and usually “tested … the underlying economic model” rather than “verify the basic prediction of the theory”. Were. He added: “Economics cannot claim to be a scientific field if its main principles are not subject to empirical testing and possible rejection.”

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Nowadays, populist rightists and progressive leftists regularly attack economists as tone-deaf elitist framing free-market dogma as science. In a decidedly non-central banker footnote, Mr. Rudd hints that he may agree: “I leave with deep concern that the primary role of mainstream economics in our society is a criminally oppressive, unstable and unjust social To offer an apology for the arrangement.”

While Mr. Rudd may lack the stature of this week’s Nobel laureates, his criticism of Fed policy has stirred up a hornet’s nest as it draws from within the Fed’s professional ranks, usually for technical prowess. Known to flourish, not controversial. He has worked at the Fed since 1999. Former aides described Mr Rudd as discreet, reserved and “somewhat sly”.

“He’s a pretty quiet economist most of the time,” said Jonathan Wright, a former colleague now at Johns Hopkins University. “At the same time, he can release these thunderbolts.” (Mr. Rudd declined to be interviewed via a Fed spokesman.)

His criticism begins in the 1960s when future Nobel laureates Milton Friedman and Edmund Phelps separately hypothesized that there was some natural level of unemployment determined by the structure of the economy. Monetary or fiscal stimulus can temporarily push unemployment below this level and increase inflation. But eventually, rational workers will expect higher inflation and demand higher wages to compensate, so unemployment will rise back.

As Mr. Rudd notes, Mr. Friedman and Mr. Phelps were not explaining contemporary events, but rather the demands of the theory, namely that inflation could not consistently fool rational people into working harder. Events endured them: In the 1970s, both inflation and unemployment soared. Inflation has fluctuated around 2% since the mid-1990s. Most economists and the Fed maintain that the public expects inflation to always return to 2% and thus that price or wage setting behavior will not change in response to a temporary disturbance.

Today, pandemic constraints and commodity shortages have pushed inflation above 5%. But as surveys and bond markets show that inflation expectations have not risen much, Fed Chairman Jerome Powell thinks the jump is temporary and predicts inflation will soon return to the Fed’s 2% target.

Mr Rudd, however, argues that the evidence simply does not show expectations actually drive inflation up. The key predictions of those early scholars turned out to be incorrect, and there are more plausible reasons why inflation has remained below stable expectations, he says. They argue that changes in public behavior occur when actual, not expected, inflation is high. External events brought down real inflation in the early 1990s and the public accordingly stopped paying attention.

Mr. Rudd’s work implies that real inflation is now so high, the public may begin to pay attention. Thus higher inflation would prove to be more sustainable than Mr. Powell thought.

Mr Wright thinks criticism of Mr Rudd is baseless. He said that central banks have always held that expected inflation is heavily influenced by actual inflation and that Mr Rudd ignores Europe and Japan whose inability to raise inflation is best explained by expectations.

Economic models indeed generally assume that people act rationally, but Mr. Wright said that without such a theoretical foundation, economics has no basis: “You can claim anything.”

This is already evident in the minimum wage debate. Because studies show that small increases don’t hurt employment, advocates claim larger increases, such as $15 an hour, won’t either. That logic could increase the minimum to $20 or $30 without harming jobs. If inflation expectations don’t matter, high inflation will remain here until the Fed raises interest rates now and acknowledges the cost of income and jobs previously incurred.

Ultimately, evidence and theory matter less for good decisions than being open-minded enough to know when either side leads you astray. The most encouraging aspect of this latest attack on Fed policy is that the Fed itself was prepared to publish it.

write to Greg IP [email protected] . Feather


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