Wednesday, November 18, 2009

Lacker on Inflation

Here is an interesting statement by Richmond Fed President Jeffrey Lacker on the state of monetary policy in the US:

There is no doubt that we must be aware of the danger of aborting a weak uneven recovery if we tighten too soon. But if we hope to hold inflation in check, we cannot be paralyzed by patches of lingering weakness, which could persist well into the recovery. ...

The historical record suggests that the early years of a recovery is when the risk is greatest that confidence in the stability of inflation erodes and we see an upward drift in inflation and inflation expectations.

Lacker's statement has been considered hawkish by analysts, however it's textbook-precise. As an example, see this graph from Cecchetti's "Money, Banking, and Financial Markets" textbook showing the behavior of inflation in the US during the sixties and seventies:



Average GDP growth rates kept falling from 1966 to 1980 in the US. The Fed tried to stimulate the economy with a loose monetary policy stance, but the end result wasn't growth, was inflation. To make things worse, inflation rarely creeps up slowly. It rises in unstoppable bursts. The bursts reinforce the inflationary trend because they produce periods marked by sizable negative ex-post real interest rates, hurting savers and destroying their confidence on the monetary authority. Meanwhile, the bursts aggravate the tendency of central bankers to underestimate the ex-ante nominal interest rate levels that are necessary for price stability.

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